The Best Europe ETF for 2015

The VGK ETF is the contrarian play

Retail investors are notorious performance chasers, and that has certainly proven to be the case recently when it comes to Europe ETFs.

While WisdomTree Europe Hedged Equity Fund (NYSEARCA:HEDJ) is the hot ETF of the moment, investors should take a closer look at the contrarian opportunity available in the Vanguard FTSE Europe ETF (NYSEARCA:VGK).

Strong Performance = Massive Inflows to HEDJ

Since the beginning of June, the crash in the euro has led to a huge disparity between hedged Europe stock ETFs and their unhedged counterparts. While VGK has lost 11.1% in that time, HEDJ has gained 7.5%. As a result, any investor who bet right on the market but was wrong on the currency aspect has cost themselves a tremendous amount of performance in a very short time.

This return gap hasn’t been lost on investors. According to etf.com, HEDJ has hauled in $976 million so far in 2015, placing it fifth among all ETFs in that interval. VGK, for its part, has lost nearly $100 million. Looking further back, HEDJ has taken in $4.9 billion since June 30, versus outflows of $4.2 billion for VGK.

This $9.1 billion gap in less than seven months is the very definition of a crowded trade — particularly when you’ll be hard-pressed to find an analyst calling for anything other continued dollar strength in 2015.

HEDJ vs. VGK, 1-Year
Source: bigcharts.com

The Contrarian Play

Therein lies the problem with favoring hedged Europe ETFs over their non-hedged counterparts at this point — or, for that matter, pressing the bet against the euro via ETFs such as CurrencyShares Euro Trust (FXE). The falling euro is the among the most well-known trends in the financial markets right now — so much so that a recent Wall St. Journal article on the prospects of the euro falling to parity with the U.S. dollar was one of the featured links on the Drudge Report on Saturday morning.

FXE, 1-Year
Source: bigcharts.com

What Would it Take to Reverse the Euro’s Slide?

The excessive “popularity” of an investment theme isn’t the sole reason to take the other side of the trade, but some important factors point to a stabilization of the euro — and stronger relative performance for VGK and other unhedged ETFs.

To see why, it pays to look at the key drivers of the euro’s recent collapse: the stronger growth of the U.S. economy, the expectation that the U.S. Federal Reserve will employ tighter policy than the European Central Bank, and the relative attractiveness of U.S. Treasury yields vs. European government bonds.

All of these pillars remain in place for the time being, and one — the gap in bond yields — is unlikely to change any time soon given the distance between the 10-year U.S. Treasury (1.82% at Friday’s close) vs. the 10-year German bund (0.36%).

However, the other two drivers — the growth divergence and the gap in central bank policy — are now well-known issues. These trends are widely expected to continue, meaning that the element of surprise clearly works in favor of the euro, and by extension, unhedged Europe ETFs.

Take economic growth: The current thinking is that the United States will continue to de-couple from the rest of the world, maintaining its robust expansion even as the global economy weakens.

But history has taught us that basing investment decisions any “de-coupling” story is a dangerous game. Further, all of the room for surprise is on the downside here given that the U.S. economy is fully expected to outperform. As a result, any sign of weakness here in the United States could help firm up the euro.

The story is the same when it comes to Fed policy. If it’s one thing that investors can agree on right now, it’s that the Fed is going to raise rates at some point in 2015. But what happens if the Fed raises rates later than expected, doesn’t raise at all, or indicates that its pace will be more gradual than investors anticipate?

These possibilities aren’t out of the question, given the potential deflationary impact of falling energy prices, the strong dollar and the possibility that deflation could be exported to our shores from overseas. The possibility of a surprise in the direction of Fed policy therefore favors a recovery in the euro vs. the dollar.

These are key considerations right now, given that the euro’s decline is approaching the point where both its duration and magnitude are moving into the range of past downturns, as shown in the accompanying chart. The euro has now reached a level that has acted as longer-term support in the past.

Euro, 2000-present
Source: investmentools.com

Could the euro continue to decline in the weeks ahead? Absolutely — currency moves can always go on much longer than anticipated. Still, the risk-reward equation has begun to shift in favor of a stronger euro, if for no other reason than the element of pain further declines would inflict on the investment community. This may be evident in Monday morning’s market action, when the expected victory of the anti-austerity Syriza party in the Greek elections was followed by a small gain in the euro, rather than a decline.

The Bottom Line

If you’re considering a contrarian play on European equities, take care not to get caught up in the popularity of hedged ETFs like HEDJ or Deutsche X-trackers MSCI Europe Hedged Equity ETF (NYSEARCA:DBEU). The majority of the performance gap between the two categories may now be largely behind us, which makes the case for unhedged ETFs such as VGK.

At this point, such funds offer a contrarian investment not just in the region’s soft equity markets, but also the currencies. This trade may not be rewarded immediately, but by year-end investors in VGK are likely to come out ahead.

As of this writing, Daniel Putnam did not hold a position in any of the aforementioned securities.

More From InvestorPlace


Article printed from InvestorPlace Media, https://investorplace.com/2015/01/best-europe-etf-for-2015/.

©2020 InvestorPlace Media, LLC