What’s Next for European Currency Hedging?

A few years ago, currency hedging was a phrase known only in select circles of the professional investment community. Following Prime Minister Shinzo Abe’s ascent to power in Japan, currency hedging with exchange-traded funds became popular.

WisdomTree185Thanks to Abe’s commitment to weakening the yen in a bid to prop up Japan’s export-driven economy and end a multi-decade spiral into deflation, the WisdomTree Japan Hedged Equity Fund (DXJ) went from just another Japan ETF to a currency hedging force that today has over $16.1 billion in assets under management.

With other global central banks, notably the European Central Bank, unleashing large-scale quantitative easing programs at a time when there is rampant speculation the Federal Reserve will raise interest rates in a matter of months, currency hedging has become the toast of the ETF town.

Year-to-date, three of the top 10 asset-gathering ETFs, including the top two, are currency hedged funds. And no ETF has hauled in more new assets this year than the $15.5 billion added by the WisdomTree Europe Hedged Equity Fund (HEDJ).

What a lot of investors have forgotten is that, just a few years ago, HEDJ was not HEDJ as they know it today. It was a multi-region, multi-currency ETF until WisdomTree decided to reconfigure the fund as a currency hedging tool focused solely on European stocks that pay dividends. Today, HEDJ is arguably the premier ETF avenue for accessing European stocks.

HEDJ Leads Currency Hedging ETFs

The aim of currency hedging is to provide investors upside equity exposure while profiting from strength in the U.S. dollar, usually against developed market currencies such as the euro or yen, though ETF issuers are rapidly expand their currency hedging offering.

Said another way, an ETF like HEDJ is vulnerable to euro strength/dollar weakness more so than a non-hedged rival like the Vanguard FTSE Europe ETF (VGK).

Aided by the ECB’s quantitative easing program rollout early this year, European stocks and HEDJ surged through the first quarter and into the early second quarter, but over the past six months, HEDJ has tumbled. The good news is investors are trading the ETF as a long-term investment, not a short-term, hot money trading vehicle.

Currency-hedged ETFs have been the story of the year in terms of flows. And while they didn’t take in any money in September, they didn’t lose any either.

Investors appear unfazed by declines in the $20 billion HEDJ, which invests in eurozone stocks while hedging against the currency exposure. The fund has fallen 17% in the past six months, without significant outflows. This is in contrast to how fast $19 billion came in when the ETF started outperforming a year ago.

The DXJ also has retained assets amid underperformance. The surprisingly sticky assets indicate the products are used more by “long-haul” investors than by traders looking to make a quick buck, according to Bloomberg’s mid-September ETF review.

Investors have other options when to comes to currency hedging and European stocks. In fact, a new small-cap kid on the block has actually been better than its large-cap counterparts. The WisdomTree Europe Hedged SmallCap Equity Fund (EUSC) debuted in March as the small-cap answer to HEDJ.

Today, EUSC is a $220 million ETF, making it one of the most successful new ETFs to come to market this year. EUSC has outperformed HEDJ by nearly 700 basis points over the past six months.

EUSC is an interesting avenue to currency hedging and European stocks because it is perhaps the only eurozone ETF where Germany or France is not the fund’s largest country weight. Rather, Italy, the eurozone’s third-largest economy is EUSC’s largest country weight at 21.3%. That is more than seven times the Italy weight found in HEDJ.

Bottom Line on Currency Hedging ETFs

Due to a spike global financial market volatility in August, the euro, believe it or not, became a safe haven. But that doesn’t mean the currency hedging theme and European stocks should be off investors’ lists.

“I believe the more dramatic sell-off in many of these European markets offers an opportunity. Valuations have come down, and there is no less of a commitment from the European Central Bank to support the economic environment,” said WisdomTree Research Director Jeremy Schwartz in a recent note.

So, while some investors might be wary of wading into currency hedging ETFs right now, it’s hard to imagine a better time to get into EUSC and HEDJ.

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

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Article printed from InvestorPlace Media, https://investorplace.com/2015/09/hedj-currency-hedging/.

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