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Over the last week, Europe has become the center of the investing world, as all eyes have focused on the ongoing Greek financial tragedy. The proposed bailout package has been through countless iterations, as conflicting reports over the severity of Greece’s financial health have sent neighbors and the IMF repeatedly back to the drawing board. There are concerns that the latest aid package – which several European neighbors have reluctantly agreed to support – will only delay a fiscal collapse until late next year if capital markets don’t sense that sufficient progress has been made. Moreover, protests in Greece against proposed austerity measures have raised doubts over the ability of the Greek government to slash its costs as promised.

All of this, combined with cuts to credit ratings of the much larger Spain and Portugal, have placed significant downward pressure on the euro, which was recently worth about $1.32 (the eurozone currency opened 2010 at about $1.44, or about 8% higher than its current level). Most US investors have probably viewed this as a positive development; dinners in Paris and Gondola rides in Venice just got a lot more affordable. But they might be singing a different tune if they fully grasped the havoc a crumbling euro is wreaking on asset values.

Most equity ETFs available to US investors don’t hedge out currency exposure, meaning that the total return is comprised of both changes in the local share price and currency fluctuations. So if any of the $7 billion in Europe equity ETFs or $33 billion in the iShares MSCI EAFE Index Fund (NYSEARCA:EFA) are yours, the euro’s freefall may be costing you more than you think.

HEDJ vs. EFA

This phenomenon is perhaps best illustrated by examining the performance of two ETFs offering exposure to the EAFE economies, one of the most popular ways to gain ex-U.S. exposure to developed equity markets. EFA, which tracks the MSCI EAFE Index, is one of the largest US-listed ETFs by assets, and a component of many investor portfolios. This ETF tracks the performance of European, Australasian, and Far East markets, essentially covering the world’s advanced economies (with the exceptions of the US and Canada).

As shown below, EFA has lagged behind another ETF offering exposure to EAFE equities, the WisdomTree International Hedged Equity Fund (NYSEARCA:HEDJ), in 2010:

(Click to enlarge)

So what’s the reason for this gap between two generally similar ETFs? The answer is pretty simple; EFA maintains exposure to the euro, while HEDJ doesn’t. HEDJ is linked to an index that “neutraliz[es] exposure to fluctuations between the value of the U.S. dollar and non-U.S. currencies reflected in the index.” In other words, this ETF uses forward currency contracts or futures contracts to offset exposure to non-US currencies. So in addition to European, Japanese, and Australian equities, the underling holdings of HEDJ consist of currency contracts.

It’s worth noting that HEDJ is linked to a dividend-weighted index, while the benchmark underlying EFA is cap-weighted. So differences in return between EFA and HEDJ are also attributable to differences in weighting methodologies. WisdomTree’s DEFA Fund (NYSEARCA:DWM), which offers non-hedged, dividend-weighted exposure to the EAFE region, has actually lagged EFA on the year. This implies that HEDJ’s dividend-weighting strategy has actually had an adverse effect; if components were cap-weighted the delta between EFA and HEDJ would presumably be even larger.

Interesting Alternative

Europe’s recent troubles are more reflective of questionable fiscal policies than they are of deteriorating business fundamentals. So for investors looking to maintain their exposure to European equities – or perhaps to increase exposure in anticipation of a rebound – HEDJ is an interesting alternative to EFA. Currency exposure is, of course, a two-sided coin. If the euro rebounds against its major rivals, unhedged exposure to the region may produce better returns.

Many investors elect to steer clear of currencies, equating this asset class to glorified gambling in a zero sum game. What they may not realize is that exposure to exchange rate fluctuations is built in to many of the ETFs currently available. For some that’s just fine; there are those who are happy to take the ups and downs. But for those who want to invest in Europe without the euro exposure (and Japan without the yen exposure, etc.), HEDJ might be worth a closer look.

Disclosure: No positions

Source: EFA vs. HEDJ: A Better EAFE ETF?