Time to Hedge Euro Risk?

Buoyed by the flight to riskier assets, the euro is off to a solid start against the U.S. dollar this year. That much is proven by the CurrencyShares Euro Trust (NYSE:FXE), which was up 2.2 percent year-to-date at the start of trading Wednesday.

Following a surge for European equities last year, some investors may be left thinking everything is fine and dandy with the common currency used by 17 nations. After all, at the ETF level, it was those funds that assume currency risk that were inflow leaders in 2012.

A case can be made that things are improving in the Eurozone, but that can be countered with the notion that the euro is not yet out of the wood. That means investors should consider a hedge to currency risk when evaluating European equities and the corresponding ETFs.

"I believe both the euro and the U.S. dollar have their fair share of potential weaknesses," said WisdomTree Research Director Jeremy Schwartz in a new research note. "Ultimately, the situation begs the question: Should investors trying to capture the relatively low prices of European stocks take on additional euro risknamely positioning themselves so that their investments may decline from a weakening euro compared to the U.S. dollarin doing so?"

Some of the largest Europe-focused ETFs have continued to impress in 2013 after surging last year. For example, the iShares S&P Europe 350 Index Fund (NYSE:IEV) has gained 5.1 percent year-to-date while the SPDR EURO STOXX 50 (NYSE:FEZ) is up about 4.9 percent. The rub with both funds is that each leaves investors vulnerable to potential euro weakness.

"It is widely understood that currency performance can add significant volatility to international equity returns, but the difficult question regards whether investors receive compensation, i.e., a potential increase in their returns, for taking on this additional risk," Schwartz said in the note.

Investors that want to embrace the attractive valuations still being offered by some European stocks while skirting currency risk have options, including the WisdomTree Europe Hedged Equity Fund (NYSE:HEDJ). In rough terms, HEDJ is the hedged euro equivalent of the wildly popular WisdomTree Japan Hedged Equity Fund (NYSE:DXJ).

HEDJ is "designed to have higher returns than an equivalent non-currency hedged investment when the value of the U.S. dollar is increasing relative to the value of the euro, and lower returns when the U.S. dollar declines against the euro," according to WisdomTree.

As DXJ does with Japan, HEDJ screens possible constituents to ensure the fund's holdings are not heavily dependent on the Eurozone for the bulk of their revenue.

Top-10 holdings in HEDJ include companies with significant global exposure such as Anheuser-Busch InBev (NYSE:BUD), Unilever (NYSE:UN), SAP (NYSE:SAP) and Sanofi (NYSE:SNY).

The emphasis on trimming currency volatility has not hampered HEDJ's returns. WisdomTree altered the ETF's composition to focus solely on European dividend payers that derive the bulk of their sales outside the Eurozone in August 2012. Since August 30, the ETF has soared almost 17 percent.

Investors have bought into HEDJ's new look. On August 21, the ETF had just $15.3 million in assets under management. As of January 29, that total had surged to $39.4 million, indicating that some investors are heeding Schwartz's advice to hedge their euro exposure.

"Bottom line: Investors should consider how much conviction they have in the potential performance of the euro against the U.S. dollarand if the answer is that they have no idea as to its future direction, which I suspect is the case for many, they ought to consider hedging that risk, if they are truly trying to capture the equity opportunity," said Schwartz.

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