The Allure Of Europe ETFs

This year, allure and Europe ETFs probably do not belong in the same sentence. After all, investors have been tantalized by the prospect of more stimulus from the European Central Bank (ECB) only to be left disappointed and tormented by issues ranging from Brexit, Deutsche Bank AG (USA) (NYSE:DB)'s quasi-Lehman Brothers moment and the fragility of banking systems in major economies such as Italy.

Indeed, these are trying times for investors mulling European equities and the related exchange-traded funds, but these could also prove to be times during which investors wish they had scooped ETFs such as the WisdomTree Inter Hedged Eq Fund (NYSE:HEDJ).

A Little More About HEDJ

HEDJ tilts more toward dividend-paying eurozone exporters, a plus at a time when the euro remains vulnerable to further downside. Additionally, the ETF's less than 12 percent weight to financial services stocks is light compared to other ETFs. Three other sectors command larger weights in HEDJ than financial services.

The third-largest, consumer discretionary, command's nearly 50 percent of HEDJ's weight than do bank stocks. Importantly, HEDJ features no exposure to troubled Deutsche Bank or Italian banking shares. Plus, eurozone equities are inexpensive.

For starters, while we say in the U.S. that stocks look expensive on a raw price-to-earnings (P/E) multiple basis, a proper fair value model incorporates the discount rate to value future cash flows. Historically low interest rates in the U.S. suggest that U.S. equities are perhaps reasonably valued given the low discount rates that are central to market valuations, said WisdomTree Research Director Jeremy Schwartz in a recent note. In Europe, the earnings multiples are even lowerand the resulting earnings yields higher and the bond yields are even lower than those in the United States.

But Does It Work?

Data suggest HEDJ's methodology works. Over the past three years, not only has HEDJ been slightly less volatile than the MSCI EMU Index, the WisdomTree ETF has outperformed that index by an almost 20-to-1 margin. That serves as a reminder of the unintended consequences of investors not acknowledging currency risk.

With the Federal Reserve potentially nearing an interest rate hike before the end of this year, some U.S. companies could face a strong dollar headwind while their eurozone rivals could get the benefit of a weak euro tailwind, possibly lifting HEDJ in the process.

If the U.S. has this headwind that can continue to be a relative drag on earnings going forward and European markets have a bit of a tailwind for earnings, this could make the valuation argument even stronger and help make a case to look more positively on European equities, added Schwartz.

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