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By Jeremy Schwartz

At his May 8, 2014, press conference, European Central Bank president Mario Draghi stated:

I can say one thing: that certainly the strengthening of the euro in the context of low inflation and still low levels of economic activity is, as I said, a cause for serious concern in the view of the Governing Council.

Since that time, the euro has depreciated, and we believe that, even if it is not explicitly stated, the level of $1.40 is a proverbial line in the sand for Draghi. The good news for Draghi is that the euro's strength has started to abate-which means euro currency-hedged strategies are starting to work and should become a greater focus for U.S. investors looking to capitalize on the European equity opportunities.

European Central Bank Took Decisive Action; Euro Finally Reacting

On June 3, 2014, Draghi announced a set of actions aimed at helping the eurozone economy continue on the path of recovery. We wrote about them here. As is often the case with central bank policy, it takes some time for the impacts of policy changes to become apparent. The euro hadn't really moved much from June 3, 2014 ($1.3628), all the way up to July 14, 2014 ($1.3619). By July 25, 2014, it dropped to $1.3430. While some might say that doesn't seem like much, on a technical (or price-pattern) basis, there has been a deterioration of the euro's stubborn strength:

  • The euro's 50-day moving average crossed below its 100-day moving average on June 13, 2014.
  • On July 4, 2014, the euro's 50-day moving average crossed below its 200-day moving average.

While technical signals by no means predict the future with certainty, they paint a picture for the deteriorating trends in euro price activity.

Importance of Currency Hedging

Any U.S. investor excited about the prospects of a European recovery should be thinking about two things when considering equity exposure to the eurozone: the equities and the currency. Today, tools exist to mitigate the impact of currency on returns. WisdomTree has created two such Indexes:

Both provide exposure to equities without providing exposure to the euro.

WisdomTree's Euro-Hedged Indexes in 2014

(click to enlarge)

Euro Depreciates More Than 2%: While the two WisdomTree Indexes hedge the impact of the euro, the two MSCI Indexes shown do not. In a depreciating euro environment, this can be an important source of potential outperformance.

Dividend-Weighted Focus on Exporters: Both WisdomTree Indexes are weighted by dividends and focus on exporters within their respective universes. Of course, this orientation can also impact performance.

Zooming in on drivers of performance for WT Europe Hedged Equity vs. MSCI EMU:

  • Financials: Financials are currently the largest weight in the MSCI EMU Index (23.5%) but are only 13.0% of the WisdomTree Europe Hedged Equity Index. Both strong stock selection and a substantial under-weight to Financials contributed positively to performance.
  • Consumer Staples: Consumer Staples are the largest sector in the WT Europe Hedged Equity currently (21%) but are only 10% of the MSCI EMU. This was one of the best-performing sectors year-to-date, contributing positively to performance. These companies often are exporters that benefit from a weaker euro.
  • Utilities: Utilities were quite strong across the eurozone, but WT Europe Hedged Equity was hurt by being under-weight in this sector (2.6%) currently versus 6.5%.

Zooming in on WT Germany Hedged Equity vs. MSCI Germany: Additional outperformance came from strong stock selection within the Consumer Discretionary sector (average weight of more than 24%) and nearly double the weight to Germany's strongest-performing sector in 2014, Utilities (more than 8% average weight). Only two sectors-Materials and Consumer Staples-hurt relative performance.

Blending Currency Hedging with Unhedged Approaches?

We've been writing about currency hedging for some time, and we continue to advocate that, if an investor isn't sure of the future direction of an international currency-in this case the euro-the baseline exposure should not be in a 100% unhedged approach. We've seen strong interest in currency hedging within the broader eurozone region, but those looking at the performance of German equities in particular have not yet embraced the hedged concept. Given European Central Bank policy and the trend of the euro, we believe it could be time to think about currency hedging of both broad, eurozone-related equities and German equities.

Important Risks Related to this Article

Investments in emerging, offshore or frontier markets are generally less liquid and less efficient than investments in developed markets and are subject to additional risks, such as risks of adverse governmental regulation and intervention or political developments.

Foreign investing involves special risks, such as risk of loss from currency fluctuation or political or economic uncertainty.

Investments in currency involve additional special risks, such as credit risk and interest rate fluctuations.

Jeremy Schwartz, Director of Research

As WisdomTree's Director of Research, Jeremy Schwartz offers timely ideas and timeless wisdom on a bi-monthly basis. Prior to joining WisdomTree, Jeremy was Professor Jeremy Siegel's head research assistant and helped with the research and writing of Stocks for the Long Run and The Future for Investors. He is also the co-author of the Financial Analysts Journal paper "What Happened to the Original Stocks in the S&P 500?" and the Wall Street Journal article "The Great American Bond Bubble."

Source: Euro Hedging Starts To Work In 2014