Should You Hedge the Currency Risk on Your European Stocks ?

The outlook for the European economies has moved lower in the past weeks. This due to the immediate news of the crisis in the Ukraine and sanctions as well as weaker economic data. In response the European Central Bank has engaged in another round of interest rate easing with every intent of keeping this policy in place for an extended period of time. An additional goal of the policy is to weaken the Euro making exports more attractive.

Where does that leave the outlook for European stocks. I have noted in earlier blogs that the European stock markets carry significantly lower valuations than US stocks and Germany in particular has fallen sharply as a result of the Ukraine crisis.

I have also noted that investing in European stocks, particularly through the ETFs is not as much an investment in the economies of those countries but rather in a group of major multinational corporations. Those corporations carry lower valuations than US stocks but compete with them around the world. A weaker dollar will make the European companies more price competitive. Additionally remember that the weaker US economy and stronger dollar vs the Euro will hit US multinationals' exports to Europe.

1. So with the case for European stocks perhaps not as negative as the headlines should one hedge the currency risk...the impact of a lower Euro cutting into the returns of European stocks for US investors (already reflected in the US$ price of Europe ETFs trading in the US?

There are three things that I learned in over a decade working in the currency markets prior to working with individual investors.

1. Exchange rates are notoriously difficult to predict. But...
2. Exchange rates tend to move based on interest rate differentials--money flows out of low interest rate currencies to higher interest rate currencies (the "carry trade" is a major factor traders/investors borrow in the lower interest rate currency and invest in the higher.
3. Once a trend is established in currencies it tends to last for a considerable period of time...but when that reverses it reverses sharply

• With regard to  the ECU/$ exchange rate we can point to to the following factors already in place:

1.  The interest rate differential (higher dollar) in place..and the US is in a mode of  looking to raise interest rates after a long period of Central Bank policy cutting rates...the date is unknown but the direction is. The ECB on the contrary has indicated it plans to keep rates low for an extended period. In other words the interest rate differential is near certain not to reverse and the likelihood is very high it will widen
2. The ECB favors a weaker Euro
3. A strong trend towards a weaker Euro agains the $ is already in place. Ten year chart below:

What does a weaker Euro mean for investors in European stocks through a US $ denominated ETF:

a lower dollar will reduce any gains on the European stock investment and of course increase losses.

What can be done: One of the great things about ETFs is that the innovation and competition gives access to individual investors strategies that were once available only to large institutional investors. In some cases it gives them access to strategies they would be better off avoiding. But in the case of currency hedging this is a great innovation.

There are several ETFs which hedge (eliminated) the currency risk from European stock investments. Many of them are new, not liquid and have minimal assets under management...likely a good idea to avoid them However the Wisdomtree hedged European ETF(HEDJ) has none of those issues and is worth considering.Although it is tied to an index different than those of the major Euro area etfs (EMU and FEZ) the holdings are close enough to make it an effective hedge.

Here are the top 20 holdings in HEDJ with their % of the portfolio  as you can see almost all of the top holdings are major multinational companies(with the notable exception of two major Spanish banks)

1. Anheuser-Busch InBev NV (ABI) BE 6.08
2. Banco Bilbao Vizcaya Argentari (BBVA) ES 5.67
3. Telefonica SA (TEF) ES 5.65
4. Sanofi-Aventis SA (SAN) FR 4.98
5. Banco Santander SA (SAN) ES 4.77
6. Unilever NV (UNA) NL 4.42
7. Siemens AG (SIE) DE 4.27
8. Daimler AG (DAI) DE 4.00
9. Bayer AG (BAYN) DE 3.14
10. LVMH Moet Hennessy Louis Vuitt (MC) FR 2.83
11. L\''Oreal SA (OR) FR 2.82
12. Bayerische Motoren Werke AG (BMW) DE 2.80
13. E.ON SE (EOAN) DE 2.36
14. Sap AG (SAP) DE 2.32
15. Schneider Electric SA (SU) FR 1.94
16. Koninklijke Philips Electronic (PHIA) NL 1.87
17. Danone (BN) FR 1.74
18. Heineken NV (HEIA) NL 1.35
19. ACS Actividades de Construccio (ACS) ES 1.35
20. Airbus Group (AIR) NL 1.33

As the Euro has weakened as of late due to ECB policies the use of  HEDJ has shown its usefulness not only has the currency risk been eliminated the gain on the exchange rate has offset declines in the European stocks

But ..as in all investments nothing is guaranteed, Over the last 12 months hedging away the currency risk has reduced returns over considerable periods of time.

The strategy of replacing an etf with currency risk (FEZ,EMU for example) with a hedged currency etf like HEDJ for all of part of one's European stock investment might be worth a look.

But remember that not all European ETFs contain only ECU denominated stocks. VGK for example contains a large allocation to UK stocks of course denominated in Sterling. The Bank of England has moved to a tightening mode. Between last September and the beginning of July Sterling was on a strong positive trend rising from $1.60 to $1.70...before falling back to close to $1.60 since July in response to the possibility Scotland will vote to breakaway from the UK....thus demonstrating how difficult exchange rates are to predict.