Matthew Kerkhoff, options expert and editor of Dow Theory Letters, continues his 14-part educational...
Is it Time to Hedge Europe?
02/13/2013 7:45 am EST
Samuel Lee of Morningstar ETFInvestor investigates a fund that would prosper as the euro slides...but is that the best course of action right now?
My go-to European stock fund is Vanguard MSCI Europe ETF (VGK). Any alternative investment needs to be better than this fund—a tough feat.
WisdomTree Europe Hedged Equity (HEDJ) is an intriguing choice, but with a potentially fatal drawback: Abysmally low assets—about $35 million as of this writing. That impedes liquidity and raises the prospect of premature closure and liquidation.
However, I believe HEDJ merits consideration, if you know how to trade low-volume ETFs and are willing to bear the small, but increased probability of an untimely liquidation.
Typical of a WisdomTree fund, HEDJ weights its holdings by annual cash dividends paid. HEDJ’s investment case is clear: European equities are cheap, but could become a lot cheaper if the Eurozone blows up, so hedge euro exposure and own firms that do much of their business outside of Europe.
A common mistake in investing is to assume that bad news surrounding a market means it’s a bad time to invest in it, and really bad news means it’s a really bad time to invest. It doesn’t matter how bad the news is, as long as the price is low enough to justify poor fundamentals.
Consider Greek equities. If you could own the whole market for a penny, you’d be a fool not to do so. At that price, you effectively have a free call option that allows you to participate in any upward move while capping your losses at a single red cent.
Even if the Eurozone breaks apart, I still think the intrinsic value of European equities will hold up, simply because the firms derive so much of their revenues from abroad—about half, compared to about 37% for North American firms.
There are two costs to this hedging strategy: Implicitly, there’s the higher valuations any such exporters may command, and explicitly, there’s the cost of owning and rolling over currency forwards.
We can estimate the valuation premium for exporters by looking at the difference in fundamental ratios. The WisdomTree Europe Hedged Equity Index yields 3.3%, and its price-to-book ratio is 1.8, suggesting the higher-quality exporters are about 15% to 20% more expensive than the broad European market.
The premium may be justified, because exporters tend to be quality firms—household names like Bayer (BAYRY), Unilever (UL), and Buffett-favorite Sanofi (SNY)—with higher returns on equity and more stable earnings.
On the benefits side of the ledger, I’d peg the probability of the euro collapsing versus the dollar by more than 15%, at about 15% over the next year and 20% to 30% over the next two years. I’d peg a general euro decline relative to the dollar over the next ten years at greater than 60%, because Europe still has mountains of debt it will need to debase.
The path of least resistance to this problem is inflation and currency depreciation. While high inflation is bad for equities, currency depreciation is good for them in general and great for exporters, in particular. In the ideal case of a steady euro slide, and moderate inflation, HEDJ would do very well.
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