Top-Of-Class European Performance by Jeremy Schwartz, Director of Research, The WisdomTree Blog
European markets are dominating headlines this year, from both an economic policy front, with Mario Draghi unleashing a fresh round of monetary stimulus, and a market performance perspective, with European bourses leading indexes higher and the euro tanking1.
As a result, flows are coming into European-focused funds, particularly those that hedge currency risk. In particular, the WisdomTree Europe Hedged Equity Fund (HEDJ) has seen approximately $13 billion of inflows in 2015 alone.2
Currency hedging, which has the goal of neutralizing the effect of foreign exchange rates on total return, has come into focus for U.S. investors recently, with the last few years showing how critical currency movements can be.
Looking at the peer group of European-focused mutual funds and exchange-traded funds (ETFs), HEDJ has ranked No. 1 in its peer group of Morningstar mutual funds and ETFs over the last one- and two-year periods.
Interestingly, if one goes back to the inception of HEDJ-when it was first focused on European markets while hedging the euro—which was August 29, 2012, there was only one fund that came out ahead of it3.
The one Fund that beat it from this period was another WisdomTree Fund, the WisdomTree Europe SmallCap Dividend Fund (DFE). In 2012, the euro was $1.26—it fell to $1.07 by March 31, 2015. Yet, small caps outperformed large caps enough to offset the currency drag that HEDJ was protected from.4
Figure 1: Morningstar Peer Group Ranking and Performance Data
Hedging Accomplishes Goal of Targeting Local Market Returns
Typically, traditional unhedged strategies leverage the equity return by layering currency risk on top of it. Hedging is a way to remove this leverage. Put another way:
Unhedged Return = Equity Market Return + Currency Return = Total Return (2 sources of risk/return)
Hedged Return = Equity Market Return + Currency Return – Currency-Hedged Return Neutralizer = Local Equity Markets Return (1 source of risk/return)
Overall, hedged strategies do not typically benefit significantly when currencies go up, nor do they get hurt when currencies go down. It is the unhedged strategies that either see returns increase when the foreign currency is rising or see returns hurt when these foreign currencies are weakening.
Hedging Accomplishing Goals Well
These hedged strategies are accomplishing their goal of achieving those local market returns during periods of significant euro weakness. Note that over the last 1.25 years, when the euro moves really started accelerating downward, HEDJ not only kept pace with the local market return, which was up sharply, but actually provided more than 200 basis points (bps) of cumulative outperformance, even after fees.
Figure 2: Cumulative Performance
For current performance of HEDJ, visit the WisdomTree Europe Hedged Equity Fund page.
Is It Too Late to Adopt Hedged Strategies?
One question we are often asked about this currency-hedged European strategy: Has the euro move already been made, and is it too late to move toward a hedged approach?
Here I favor the positioning by Andre Perold and Evan Schulman’s paper from the Financial Analysts Journal in 1988, “The Free Lunch in Currency Hedging: Implications for Investment Policy and Performance Standards.” They wrote:
In this article we argue that it is better to formulate long-run investment policy in terms of hedged portfolios than unhedged portfolios. The key to our argument is that, from the perspective of long-run policy, investors should think of currency hedging as having zero expected return. Therein lies the free lunch. On average, currency hedging gives you substantial risk reduction at no loss of expected return. Our prescription does not say the prescient investor should not selectively lift a hedge, just that hedging should be the policy, and lifting the hedge an active investment decision.5
Getting Paid to Hedge
If you believe the euro is going to enter a strong rally, lift the hedge as an active decision. But you should realize taking euro risk is equally an active decision—when it is essentially a zero-cost option to get euro risk hedged. In fact, it is currently even better than a zero-cost option, as U.S. investors are being paid a small amount to hedge euro risk based on interest rate differentials to implement the euro hedge.6
Given these dynamics, euro-hedged strategies in many ways offer better long-run policy portfolios, and the unhedged strategies should only be used when an investor has a strong view the euro is going to appreciate.
We spoke with analyst Marc Chandler7, who believes 0.85 cents per euro is a very real possibility. I am not sure if that level will be reached, but I believe Marc makes just as strong a case as the analysts who say the U.S. dollar move is done and it can head back to $1.20 per euro.
Again, unless an investor has a clear idea the euro is on track to appreciate, the currency risk is just extra noise, and we’d suggest targeting the local equity market returns via hedged strategies.
1Source: Bloomberg, 12/31/14–4/24/15.
2Sources: WisdomTree, Bloomberg, 12/31/14–4/24/15.
3Sources: WisdomTree, Morningstar, 9/1/12–3/31/15
4Sources: WisdomTree, Bloomberg, 9/1/12–3/31/15.
5Andre F. Perold and Evan C. Schulman, “The Free Lunch in Currency Hedging: Implications for Investment Policy and Performance Standards,” Financial Analysts Journal, May?June 1988.
6Sources: WisdomTree, Bloomberg, 3/31/15.
7Marc Chandler is Global Head of Currency Strategy at Brown Brothers Harriman.
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. Funds focusing their investments on certain sectors and/or smaller companies increase their vulnerability to any single economic or regulatory development. This may result in greater share price volatility.
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. As these Funds can have a high concentration in some issuers, the Funds can be adversely impacted by changes affecting those issuers. Due to the investment strategy of these Funds, they may make higher capital gain distributions than other ETFs. Please read the Fund’s prospectus for specific details regarding the Fund’s risk profile.