Academic research has shown that investors have a strong bias toward investing in their home markets. Whether this costs them money or not depends on whether they hedge foreign exchange effects and the specific time period and markets you look at. For the past 7 years, US investors have been rewarded for this bias, but it might be time to reconsider in light of the money you can make by buying value in Europe and elsewhere and then getting paid to hedge out currency exposure. Once you understand the mechanics of how stocks and currencies move, you'll see that this creates an opportunity to be contrarian and take advantage of value. In the first section of the article, I'll explain why Europe is cheap. In the second section, I'll explain how hedge funds are playing it, and in the third section, I'll show you how anyone can join the trade using ETFs.
1. Why international stocks are cheap (Europe in particular)
1. US stocks benefitted from a free profit boost of roughly 21.5 percent from the corporate tax cuts in 2017. Earlier, a company that may have had $100 in taxable income would have $65 after tax. Now, thanks to the Trump tax cuts, it gets to keep $79 (assuming that the effects of loopholes are similar before and after the tax cuts). This market expectation of higher profits drove US equities up over 20 percent in 2017. It was a great year to be long US stocks, but make no mistake, the gains were driven by tax cuts. The gains were and are real, but the tax cuts were a one-time adjustment in corporate profits that unlocked value in US equities, and one that won't repeat in the future. The 21.5 percent gain in baseline corporate profits in US stocks goes a long way towards explaining the outperformance of US stocks over European stocks.
2. The dollar has strengthened considerably over the last 6-7 years, creating value for those willing to use their dollars to buy cheaper assets abroad. Valuations abroad are now lower than they are domestically. This creates interesting situations like the fact that you can buy global real estate and make more in rent than buying real estate locally, or can get higher dividends abroad. Everything from dividends to rents to corporate profits abroad are low in dollar terms. In other words, globally speaking, your dollar takes you 27 percent further than it did 7 years ago. Additionally, interest rates are currently higher in the US than they are in Europe, meaning that you can hedge your currency exposure and get paid about 2.4 percent per year to do so. More on how this works in a second. This won't work in all international economies, however, as many emerging markets have higher interest rates than the US. Europe currently offers a nice combination of low valuations, low expectations, and positive carry from hedging the currency from the perspective of an investor located in the United States.
2. The mechanics of the trade for hedge funds
Investors located in the US can exploit these situations by putting money to work abroad. This allows you to buy cheap stocks with high dividends and get paid to hedge the euro exposure to double dip on income.
For example, a US hedge fund buys $1,000,000 worth of stocks in Europe. Since the assets are denominated in euros, this exposes them to currency risk. Essentially, you have a short position in your home currency when you invest abroad unhedged because you have to convert the foreign stock back into dollars when you sell. To fix this, the fund might hedge the euro out of the stocks by shorting $1,000,000 worth of euros. Because of covered interest rate parity, they earn (or pay) the difference in interest rates between currencies. The dollar interest rate is currently 2.4 percent and the euro is 0. As a ballpark estimate, they should make about $24,000 per year off the currency hedge. The currency exposure from the stock position and the currency hedge then cancel, leaving them to pocket the difference.
As dividends are higher in Europe due to the lower valuation, investors playing this should additionally make about $35,000 per year in dividends. That's a yield of almost 6 percent, and they profit from any mean reversion in the price differential between US and European equities, which is more likely than not over the long run. Sure, the eurozone has problems, but the problems are more than reflected in the difference in valuation and currency differentials. Indeed, once you correct for the Trump tax cuts and the currency changes, returns have been about equal over the last 7 years for US and European equities. To this point, a Vanguard study showed that hedging currency exposure can reduce risk and increase return at the same time.
3. How you can make this trade with ETFs
For investors who are interested in this kind of trade but wouldn't otherwise be willing or able to go into the currency forward or futures market to hedge currencies, ETFs provide a ready solution.
The simplest way for most traders to play the trade is the iShares Currency Hedged MSCI EMU ETF (HEZU). It costs 0.50 percent per year, but you do benefit from the themes I discussed earlier in the article, and you don't need more than a thousand dollars to make a cost-effective trade, especially if your broker has HEZU as commission-free or you have a low-cost structure. I don't think HEZU pays out the currency differential as a dividend, but you can see that it shows up in the increased return. Another good choice is the Deutsche X-trackers MSCI Europe Hedged Equity ETF (DBEU), which has exposure to Switzerland and the UK too.
Source: Portfolio Visualizer
HEZU tracks a riskier basket of shares than DBEU does, but you can see that both have strongly outperformed unhedged positions. Historically, this is the case more often than not for US investors, especially on a risk-adjusted basis. Higher interest rates in the US provide a continual tailwind for investors that choose to hedge. If interest rates were to eventually be higher in Europe than the US you might reconsider hedging, but it's pretty hard to argue with the math right now.
For those who don't need a perfect hedge, the Vanguard International High Dividend Yield ETF (VYMI) offers value factor exposure and a heavy euro component. Alternatively, you could use the Vanguard FTSE Europe ETF (VGK). You could then go out in the futures market and short the euro, although there is a $100,000 contract minimum for the euro. You'd then have a carry trade going that moves opposite of your corresponding stocks, providing diversification. This is cheaper than using an ETF and gives you more control/ability to express investment opinions.
For the ETFs that aren't fully invested in the eurozone, the good thing is that the greater the trade ties between the country and the euro, the higher the correlation. For example, the British pound, the Swiss franc, as well as smaller currencies like the Polish zloty and Swedish krona are all more or less tied to the euro over the medium term.
Personally, I'd use this trade as part of a diversified macro strategy, where it's just one piece of the puzzle. My vehicles of choice would be to use VYMI and to use the futures market to put on a long/short basket of currencies that includes a net short euro position and reflects the other themes I believe in. This would then be combined with other strategies across asset classes, and total exposure would be adjusted for the level of global risk at any given time. This likely doesn't matter for your portfolio, however. What's important for you to know, though, is that European stocks are cheap, the euro is profitable to hedge against the dollar, and that there are a variety of ways to profit from this situation.
International investing works quite well if you understand currencies and pick undervalued markets. Cheap European stocks offer potentially strong risk-adjusted returns that can diversify your portfolio away from being all in on the United States. Research shows that hedging FX reduces risk for US-based investors, and in a positive carry environment like right now, you can get paid money to reduce your risk. Additionally, investing abroad gives you superior diversification over the long run and increases the chances that you'll be able to meet your long-run financial goals.
P.S. The strong dollar means it's a great time to travel the world or send your kids to study abroad. Pro tip: Always pay in local currency with a credit card if you're allowed (no international transaction fee cards are a must). When you use the ATM, always withdraw in local currency rather than lock in the bad exchange rates in dollars. Foreign exchange is a massive industry that profits from asymmetrical information, and the more you know about it both for business/investing and personally, the greater the opportunity set is for your life/wealth.
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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.