European markets are dominating headlines this year, from both an economic policy front, with Mario Draghi unleashing a fresh round of monetary stimulus, and a market performance perspective, with European bourses leading indexes higher and the euro tanking1.
As a result, flows are coming into European-focused funds, particularly those that hedge currency risk. In particular, the WisdomTree Europe Hedged Equity Fund (HEDJ) has seen approximately $13 billion of inflows in 2015 alone.2
Currency hedging, which has the goal of neutralizing the effect of foreign exchange rates on total return, has come into focus for U.S. investors recently, with the last few years showing how critical currency movements can be.
Top-of-Class Performance
Looking at the peer group of European-focused mutual funds and exchange-traded funds (ETFs), HEDJ has ranked No. 1 in its peer group of Morningstar mutual funds and ETFs over the last one- and two-year periods.
Interestingly, if one goes back to the inception of HEDJ-when it was first focused on European markets while hedging the euro—which was August 29, 2012, there was only one fund that came out ahead of it3.
The one Fund that beat it from this period was another WisdomTree Fund, the WisdomTree Europe SmallCap Dividend Fund (DFE). In 2012, the euro was $1.26—it fell to $1.07 by March 31, 2015. Yet, small caps outperformed large caps enough to offset the currency drag that HEDJ was protected from.4
Figure 1: Morningstar Peer Group Ranking and Performance Data
Hedging Accomplishes Goal of Targeting Local Market Returns
Typically, traditional unhedged strategies leverage the equity return by layering currency risk on top of it. Hedging is a way to remove this leverage. Put another way:
Unhedged Return = Equity Market Return + Currency Return = Total Return (2 sources of risk/return)
Hedged Return = Equity Market Return + Currency Return – Currency-Hedged Return Neutralizer = Local Equity Markets Return (1 source of risk/return)
Overall, hedged strategies do not typically benefit significantly when currencies go up, nor do they get hurt when currencies go down. It is the unhedged strategies that either see returns increase when the foreign currency is rising or see returns hurt when these foreign currencies are weakening.