Buying Currency Hedged Europe ETFs On The Dip

Being long European stocks and exchange traded funds has not been a rewarding trade in recent weeks. Not with the CurrencyShares Euro Trust FXE rising 2.1 percent over the past month as the euro has become something of a safe-haven trade.

European stocks have been plagued by, among other downbeat catalysts, heightened speculation that Greece will depart the Eurozone (though that concern has ebbed for the moment) and the collapse of Chinese equity markets and slowing economic growth there. In fact, European stocks now trade at lower valuations than they did when the European Central Bank unveiled its quantitative easing effort earlier this year.

Still, there are some green shoots that could increase the allure of currency hedged exchange traded funds, such as the Deutsche X-Trackers MSCI Europe Hedged Equity ETF DBEU and the Deutsche X-trackers MSCI Eurozone Hedged Equity ETF DBEZ.

Related Link: An ETF That Gains As China Loses

“Unemployment in the region unexpectedly fell, while German manufacturing expanded at a faster pace. Economists project Europe's gross domestic product will grow 1.5 percent this year, the most since 2011. And analysts still predict profits for companies in the currency bloc will increase 12 percent this year,” according to Bloomberg. 

The Deutsche X-trackers MSCI EMU Hedged Equity ETF, which debuted in December, is the dedicated Eurozone play of the two ETFs highlighted here. About 59 percent of the fund's weight is allocated to French and German stocks. Germany and France are the Eurozone's two largest economies. 

While currency hedged ETFs have come under some fire recently, mainly because of the dollar's sudden bout of weakness, the advantages of hedging currency risk via ETFs cannot be overlooked.

“The risk (volatility) of a currency unhedged investment has three primary components: the volatility of the equities, the volatility of the currencies, and the correlation of the two. Currency volatility is typically less than that of equities, making the correlation figure an important contributor to overall volatility. If currencies and local market returns are positively correlated, currency exposure can add significant incremental volatility. Leaving currency exposure unhedged can typically only result in lower volatility if currencies and local market returns are negatively correlated enough to offset the volatility of exchange rate fluctuations,” said Deutsche Asset & Wealth Management head of ETF Strategy Dodd Kittsley in a recent note. 

DBEU, an ETF that is a broader Europe play, has highlighted the advantages of currency hedging this year. While the fund has traded lower, it has outperformed its two largest unhedged counterparts by an average of 195 basis points.

“If the inherent currency exposure of unhedged equities offered superior diversification benefits, then global equities could be expected to exhibit lower volatility in U.S. dollar terms than in local currency terms,” added Kittsley. “But in 90% of the rolling 5-year time periods since early 1973, currency exposure introduced incremental volatility to the MSCI World Index—actually adding risk instead of reducing it through diversification.

"Investors considering the role of unhedged currency exposure in their portfolio should ask themselves: with no expectation of higher returns, potential for incremental risk, and limited diversification benefits, why leave currency risk unhedged?”

DBEU devotes over 45 percent of its weight to U.K. and Swiss stocks. Switzerland, which is not a Eurozone member, is flirting with a recession, though narrowly avoided that fate in the second quarter.

In essence, investors that are long DBEU should be rooting for a weaker pound, franc and euro.