Last year, one of the most important investment themes was currency hedging, particularly for euro-denominated stocks. Many investors believed the euro was going to weaken on the back of quantitative easing by the European Central Bank (ECB)—and that’s exactly what happened. Versus the U.S. dollar, the euro started 2015 at 1.21 and closed the year at 1.09. With such a big move, many investors are wondering if they missed the boat.
From our perspective, to the contrary. The case to hedge the euro has gotten stronger by one very important measure: how much you are now being paid to hedge.
An important element of currency-hedged strategies involves the use of forward contracts to neutralize currency exposure. The pricing of these forward contracts is based on relative interest rate differentials. In some countries like Brazil, short-term interest rates are very high, so it can cost U.S. investors upward of 14% per year to hedge exposure to currencies like the Brazilian real. That creates an incredibly high hurdle for how much the currency has to decline before an investor breaks even on paying that hedge cost.
But the actions the ECB took in December 2015 make hedging the euro different. The ECB took its deposit rate more negative—cutting rates to -30 basis points (bps). The U.S. Federal Reserve (Fed) hiked interest rates for the first time in nine years and now has a band on its short-term rate of 25–50 bps; the midpoint of the range would be 37.5 bps. This means currency hedging is not only inexpensive—investors are actually getting paid to hedge the euro. And if/when the Fed increases rates in 2016, that “payment” will increase further.
Historical Cost of Hedging the Euro (1-Month Currency Forward Implied Rates as of 12/31/15)
From a tactical perspective, when we look at what factors can help improve the returns from a purely passive hedging standpoint, interest rate differentials are the most powerful long-run signal. Given that an investor is starting to get paid more than 50 basis points a year from the differential in interest rates, this offers a boost to returns to hedged strategies over unhedged strategies, even if the euro does not move.
Of course, if the euro appreciates, the hedged strategies will not participate in those gains, but they will be hedged against further losses in the euro if those were to occur.
WisdomTree has three exchange-traded fund (ETF) options to target euro-area stocks with a currency hedge:
1) WisdomTree Europe Hedged Equity ETF (HEDJ): Provides access to the dividend-paying exporters of Europe, which can be positioned to benefit from a decline in the euro with their goods becoming more competitively priced in the global markets. We believe these companies have not fully benefited from the fall in the euro yet, as many of them also have large amounts of business coming from the emerging markets, which have also been weak in the last year. This is our flagship ETF for euro-area-hedging strategies.
2) WisdomTree Europe Hedged SmallCap Equity ETF (EUSC): Provides access to small-cap companies of the euro area and offers exposure to a more local side of European stocks. This fund can pair nicely with the large-cap multinationals to diversify size exposure and geographic revenue mixes of the companies.
3) WisdomTree Dynamic Currency Hedged Europe Equity ETF (DDEZ): Provides access to a broad cross-section of dividend payers from the euro area and implies a dynamic currency hedge. For investors who do not want to rotate between hedged and unhedged strategies, but want to have some currency exposure when the environment is supportive of it, this fund can adapt and provide that type of tactical hedging solution.
Important Risks Related to this Article
There are risks associated with investing, including possible loss of principal. Foreign investing involves special risks, such as risk of loss from currency fluctuation or political or economic uncertainty. These Funds focus their investments in Europe; the impact of events and developments associated with the region can adversely affect performance.
The securities of small-capitalization companies generally trade in lower volumes and are subject to greater and more unpredictable price changes than larger-capitalization stocks or the stock market as a whole. The Funds use various strategies to attempt to minimize the impact of changes in the value of the euro against the U.S. dollar, and these strategies may not be successful.
DDEZ invests in derivatives in seeking to obtain a dynamic currency-hedge exposure. Derivative investments can be volatile, and these investments may be less liquid than other securities, and more sensitive to the effects of varied economic conditions. The Funds invest in the securities included in, or representative of, their Indexes regardless of their investment merit, and the Funds do not attempt to outperform their Indexes or take defensive positions in declining markets.
Due to the investment strategy of these Funds, they may make higher capital gain distributions than other ETFs. Please read each Fund’s prospectus for specific details regarding each Fund’s risk profile.
Diversification does not eliminate the risk of experiencing investment loss.
Dividends are not guaranteed, and a company’s future ability to pay dividends may be limited. A company currently paying dividends may cease paying dividends at any time.