The MSCI Europe Index, which serves as a proxy for European stock markets, delivered a respectable 5 percent gain in 2014. Yet for U.S. investors, the surging dollar wiped out those gains, generating a 6 percent loss last year on a dollar-denominated basis.
Investors quickly realized how to fix the problem: exchange-traded funds that hedge against currency moves. The WisdomTree Europe Hedged Equity Fund (HEDJ), for example, has been the leading destination for ETF investors thus far in 2015, attracting $4.3 billion in inflows through February 18, according to ETF.com. The Deutsche X-trackers MSCI Europe Hedged Equity ETF (DBEU) is the seventh most popular ETF so far this year, pulling in more than $2 billion and effectively doubling in size as a result.
Performance has begat popularity (and vice versa), as the HEDJ has gained 13.5 percent gain over the past three months and the DBEU has generated a 7.4 percent return. Compare that to a more modest 4 percent gain for the iShares MSCI EMU ETF (EZU), an unhedged European fund.
Todd Rosenbluth, director of ETF and mutual fund research at S&P Capital IQ, says HEDJ has led the pack because its focus on European companies that derive at least half of their sales outside of the EU enable the fund can better capitalize on the export opportunities being generated by a weaker euro.
Though these two ETFs target the same investment theme, they pursue distinct strategies. The HEDJ fund, for example, focuses on companies in eurozone countries with at least $1 billion in market value and which derive at least half of sales outside of Europe—a key consideration as the falling euro starts to boost export competitiveness.
This fund also weights its holdings in relation to the size of a company’s dividend. That approach leads to a 40 percent weighting in consumer stocks, with industrial/materials stocks comprising another 24 percent of the fund. Anheuser-Busch Inbev NV, Spain’s Telefonica and automaker Daimler are the fund’s top three holdings.
In contrast, the DBEU fund, which is based on the MSCI Europe Index, also includes non-euro companies based in the U.K. and Switzerland. Though many of the fund’s holdings offer solid dividends, that factor is not a consideration for inclusion in the MSCI index.
The DBEU fund, which is heavy in financials (22 percent of the portfolio) and consumer staples (19 percent), counts Nestle, Novartis and Roche Holdings as its top holdings. While the top 10 stocks in the HEDJ fund account for more than 45 percent of the fund, DBEU is much more diversified with its top 10 holdings accounting for less than 20 percent of the fund.
For investors, the big question is whether the good times can last for these funds. They can, with a few key caveats. The primary ongoing catalysts—a highly stimulative monetary policy by the European Central Bank and an increasingly competitive currency—are boosting the odds that Europe can finally break out of its extended economic malaise.
But the currency-hedged ETFs likely will eventually lose a key edge, relative to their non-hedging peers. Namely, the euro had been worth around $1.40 versus the dollar in the spring of 2014, but is now worth just $1.14. The two currencies are expected to reach parity sometime during the next 12 to 24 months, according to economists at Goldman Sachs and Deutsche Bank. In other words, if these forecasters are correct that means the currency adjustment is roughly two-thirds complete.