HEDJ: Capitalize On The Brexit Fallout

| About: WisdomTree Europe (HEDJ)

Summary

Brexit may reintroduce downward pressure on the euro thus reversing its capitulation in relation to the US dollar as witnessed over the past 6 months.

As Brexit continues to rear its ugly head and wreak havoc on international financial markets, this event may present an opportunity to realize gains in this hedged product.

If investors missed an opportunity to sell into the weakness of the euro previously then the Brexit may offer this opportunity once again.

The euro hit a 10-year low relative to the dollar and depreciated dramatically by 22% over a 12 month period leading into April of 2015.

Resistance has been seen at $1.05 (EU/USD) and the disparity between the two currencies are transient in nature thus hedged products pose risks.

Introduction:

Over a year ago I initially proposed abandoning the hedge against the euro and channeling those gains into a long non-hedged European ETF. In my previously published articles related to this thesis in 2015 (April, May and August) I posited rotating money out of the WisdomTree Europe Hedged Equity ETF (NYSEARCA:HEDJ) into a long non-hedged European equity position such as the Vanguard FTSE Europe ETF (NYSEARCA:VGK).

This thesis was rooted in three major pillars:

  1. The euro had depreciated relative to the dollar by more than 20% leading into April of 2015.
  2. The currency disparity rendered a 10-year low for the euro relative to the dollar.
  3. The euro hedge within HEDJ had been largely attributable to this outperformance over an 18 month time period through April of 2015 relative its indices.

And six months later I wrote another article adding in two additional attributes that may have further supported this thesis:

  1. The Greek crisis was behind us and while this situation was not factored in to my previous articles as a potential event, this headwind did not negatively impact the euro beyond the $1.05 resistance level.
  2. As a looming interest rate increase by the Federal Reserve was on the horizon, this inevitable event may have been priced in to some extent and thus the impact on the currency discrepancy may not be as dramatic as previously thought. This partial priced in event will thus mitigate the downside effect of the euro relative to the dollar when an interest rate increase takes place.

Now over a year later, the Federal Reserve only increased rates once and no meaningful impact was observed between the hedged and non-hedged products. The Federal Reserve held off on increasing rates recently due to stagnation of economic growth and the potential of Brexit.

Brexit Changes Things:

I never factored in the possibility that a major economic power within the EU would vote to relinquish its membership and move forward as an independent nation. As the UK proceeds with its divorce from the EU, downward pressure on the euro may present an opportunity to realize gains in this hedged product if the opportunity was missed previously. Although the UK utilizes the pound as a currency, its divorce from the EU my introduce instability throughout the region thus negatively impacting the euro as a regional currency.

Investors in the WisdomTree Europe Hedged Equity ETF had been rewarded through March/April of 2015 as the euro had depreciated relative to the dollar by more than 20% through March of 2015. However this performance has been eroded away over the past year as the euro has capitulated. HEDJ possess a hedge component exploiting this currency difference on the side of the US dollar, thus investors are rewarded as the euro weakens in relation to the dollar. I posited that this hedge may inevitably become a liability as the two currencies normalize against each other and thus back in April of 2015 it appeared time to be in the sell camp of this hedged ETF prior to this hedge component working against investors in HEDJ. I suggested, as Europe continues to strengthen throughput 2015 and beyond, investors may be better positioned in a long European holding such as the Vanguard FTSE Europe ETF as opposed to the euro-hedged HEDJ. This article revisits this thesis over a year removed to quantitatively assess the recent developments with regard to Brexit, movement in the dollar and its impact on the performance of the hedged and non-hedged ETFs.

The hedge: the depreciating euro relative to the US dollar (Pre-Brexit)

HEDJ had outperformed its non-hedged ETF counterpart VGK by a wide margin in 2014 and 2015 through March of 2015. HEDJ outperformed the non-hedged European ETF by 23% on an annual basis from April 2014 through March of 2015 (Figure 1). However that outperformance of 23% through March of 2015 had given up all of its ground and then some and has since fallen to an underperformance spread of -10.7% over the past year (Figure 2) with a -23.7% return over this time period.

Per WisdomTree, HEDJ seeks to provide investors with exposure to European equities with a built-in hedge against the euro while focusing on companies that conduct a significant portion of their business overseas (non-euro exposure).

The Index and Fund are designed to have higher returns than an equivalent non-currency hedged investment when the value of the U.S. dollar is increasing relative to the value of the euro, and lower returns when the U.S. dollar declines against the euro.

This currency hedge had played out well for investors as the euro has slid against the dollar over a 12 month period through March of 2015 (Figure 1). The euro sat at a 10-year low against the dollar with a sharp 22% depreciation seen over the previous 12 months heading into April of 2015 (Figures 3 and 4). A sharp divergence between the two currencies can be seen in figures 3 and 4, demonstrating this 20% slide. From these data, I stated that currency fluctuations are transient over the long-term, thus the euro hedge will likely capitulate in the near term.

Figure 1 - Google Finance graph displaying the returns of HEDJ and VGK from April 2014 through March of 2015

Figure 2 - Google Finance graph displaying the returns of HEDJ and VGK from April 2015 through March of 2016

Figure 3 - Google Finance graph showing the euro depreciation relative to the dollar over the previous 12 months leading into April of 2015

Figure 4 - Google Finance graph showing the euro depreciation relative to the dollar over the past 10 years heading into April of 2016.

The capitulation of the euro hedge began to unfold - Insert Brexit

Recent data had suggested that the perpetual falling of the euro may have been coming to an end relative to the dollar (Figure 4). There also appeared to be a firm resistance at ~$1.05. The euro touched down twice at or near $1.05 in March and April of 2015 (Figure 4). Given the most bullish case for the dollar, some analysts were projecting the dollar to hit $0.95 by the end of the year in 2015. Assuming that the dollar even hit that mark (which it didn't), this translated into another ~9% move after the already 22% move. I stated that investors may be safe remaining in the hedge for now without much upside given the most bullish case. Given the most bullish estimates, I stated that I'd be content capturing over 70% of that spread and rotating money out of that position into a long European position such as VGK if investors would like to maintain exposure to European equities. With the Brexit in its nascent stages this premise appears to be premature if one is still holding a position in HEDJ. If investors missed an opportunity to sell into the weakness of the euro previously then the Brexit may offer this opportunity once again.

Hedge verses non-hedge performance: HEDJ and VGK

Taking a close look at a long European ETF position via VGK in comparison to the euro hedged HEDJ over the long-term exemplifies that currency fluctuations are transient over the long-term and this euro hedge will likely continue to capitulate in the near term. In 2012 and 2013 HEDJ underperformed VGK on an annual basis at times when the euro and dollar were mostly stable relative to each other (Figure 5). This hedge play had been highly favorable for investors over the 12 month time period through March of 2015 however the currencies inevitably started to trend to the inverse of this hedge as recent data suggests. At the point of initial reversion to the mean, this hedge was essentially rendered useless and VGK outperform as it did in 2012 and 2013 (Figure 5). As the euro depreciation seems to have been arrested, HEDJ will likely continue its capitulation and underperform with any further uptick in the euro. These data suggest that VGK may be superior moving into the future and combined with the recovery in Europe, it was time to abandon HEDJ and be long European equities without the euro hedge prior to the hedge working against the investor.

Figure 5 - Morningstar annual return comparison between HEDJ and VGK through March of 2016

Conclusion:

The hedge against the euro within HEDJ is largely attributable to this outperformance over the 12 month time period through from March of 2014 through March of 2015. Considering that the euro had appeared to have capitulated from its 10-year low preceded by a sharp depreciation by more than 20% indicated that this hedge may have played out. I recommended rotating money out of the WisdomTree Europe Hedged Equity ETF into a long non-hedged European equity position such as the Vanguard FTSE Europe ETF. I stated that continued exposure to this hedge may inevitably become more of a liability as the two currencies normalize against each other and thus it may be time to take profits. I felt, based on the data that as Europe continues to strengthen throughput 2015 and beyond, investors may be better positioned in a long European ETF such as VGK. Furthermore, if the European economic strength is enough to mitigate the dollar rise after the Federal Reserve increases rates then there's limited upside remaining the hedged ETF. Taken together, this euro hedge has provided investors with great returns over a one year period (March of 2014-March of 2016) however data suggested that currency fluctuations are transient over the long-term and this euro hedge may not add any additional value to one's portfolio moving into the future beyond March of 2015. With the Brexit in its nascent stages this premise appears to be premature if one is still holding a position in HEDJ. If investors missed an opportunity to sell into the weakness of the euro previously then the Brexit may offer this opportunity once again.

Disclosure: The author sold his long position in VGK. The author does not hold shares of HEDJ. The author has no business relationship with any companies mentioned in this article. I am not a professional financial advisor or tax professional. I am an individual investor who analyzes investment strategies and disseminates my analyses. I encourage all investors to conduct their own research and due diligence. Please feel free to comment and provide feedback. I value all responses.

Disclosure: I/we have no positions in any stocks mentioned, and no plans to initiate any positions within the next 72 hours.

I wrote this article myself, and it expresses my own opinions. I am not receiving compensation for it (other than from Seeking Alpha). I have no business relationship with any company whose stock is mentioned in this article.