A Unique Way to Invest in the Eurozone

Despite the risks they face, eurozone stocks may offer good diversification benefits to U.S. investors. However, currency risk is a very real threat. Low to negative interest rates across the eurozone, coupled with lackluster growth, could cause the euro to weaken relative to the U.S. dollar.  WisdomTree Europe Hedged Equity ETF  (HEDJ) offers investors a way to gain exposure to European stocks, while hedging this currency risk.

But even after taking most of the currency risk out of the equation, European stocks still face considerable risks amid a backdrop of weak demand and economic uncertainty across the eurozone. This may explain why most broad European stock indexes are trading at a discount to their U.S. counterparts. However, this macroeconomic risk may present investors with an opportunity to buy quality multinational names that happen to be based in the eurozone at reasonable valuations. This fund attempts to offer exposure to these types of stocks. It screens for dividend-paying stocks trading in the eurozone that generate more than half of their revenues outside of Europe. It then weights its holdings by cash dividends paid. This may be a suitable core position for U.S. investors looking to profit from a potential rebound in the eurozone, while limiting currency and region-specific risk.

The fund’s dividend screening and weighting approach helps to keep volatility low. Because the fund screens for stocks that pay cash dividends, more mature and stable companies anchor the portfolio. This, along with the fund’s currency-hedging program and focus on global companies, can significantly reduce volatility. For instance, the fund’s standard deviation of returns (9.9%) since August 2012, when it adopted its current index, was considerably less than the non-currency-hedged, market-cap-weighted MSCI EMU Index’s (14.5%).

Fundamentals
The eurozone continues to suffer from structural problems. On Oct. 7, the International Monetary Fund cut its 2015 global growth because of troubles in Europe. Inflation, currently an anemic 0.3%, continues to trend lower month-over-month. The amount available for bank lending has fallen significantly and stunted growth, and poor manufacturing and service demand has kept unemployment in excess of 11%.

However, this fund’s focus on multinational companies helps limit its exposure to the European economy. Its focus on dividend-payers also helps reduce volatility, giving investors exposure to a portfolio of companies with relatively stable businesses and good profitability. For instance, over the trailing 12 months through September, the fund’s holdings generated a higher return on invested capital (10.2%) than the broad market-cap-weighted eurozone MSCI EMU Index (9.2%). Dividends constrain managers’ ability to invest in low-return projects or make acquisitions and tend to be associated with shareholder-friendly management teams. Many of the fund’s holdings are well-regarded household names, such as  Anheuser-Busch Inbev SA (BUD) and L’Oreal SA (LOR).

However, this quality orientation comes at a price. At the end of September, the fund’s price-to-forward earnings multiple (17.0) was slightly higher than MSCI EMU Index’s (16.2).

The fund is not without its risks, however. Because the fund does not employ a dividend-quality screen, there is a risk that the fund’s holdings can cut their dividend during periods of economic turmoil. This could hurt the fund’s performance because of the negative message that dividend cuts signal.

Portfolio Construction
The fund tracks the WisdomTree Europe Hedged Equity Index, which offers concentrated exposure to more than 100 dividend-paying large- and mid-cap stocks in developed Europe. The index weights its holdings by annual cash dividends paid. Individual security weights are capped at 5%, while sector and country weights are capped at 25%. To qualify for inclusion in the index, each stock must be domiciled in the eurozone, trade in euros, have a market cap in excess of $1 billion, and derive at least 50% of its revenue outside Europe. The fund uses forward currency contracts and futures to hedge euro exposure.

Relative to the MSCI EMU Index, the fund offers greater exposure to consumer defensive, consumer cyclical, and industrials and less exposure to financial services, utilities, and energy sectors. The index is rebalanced annually in June. France (24.8%), Germany (24.7%), and Spain (19.9%) are the fund's largest country weightings.

The fund changed its strategy and benchmark at the end of August 2012. The previous strategy focused on a currency-hedged portfolio of broad-based, dividend-paying, developed international stocks. After the switch, the index changed its focus from developed international stocks to countries in the eurozone that derive most of their revenue outside of the eurozone.

Fees
The fund’s 0.58% expense ratio is not the lowest in the Europe stock exchange-traded fund category or even the lowest currency-hedged European ETF. Over the trailing three years through August, the fund has lagged its benchmark by 0.48%, slightly less than the amount of its expense ratio.

Alternatives
Deutsche X-trackers MSCI Europe Hedged Equity (DBEU) (0.45% expense ratio) offers currency-hedged exposure to Europe. Unlike HEDJ, DBEU weights its holdings by market cap and uses the broader MSCI Europe Index that includes non-eurozone countries such as the United Kingdom and Switzerland.

Investors looking for a less expensive European ETF may consider  Vanguard FTSE Europe ETF (VGK) (0.12% expense ratio). Unlike HEDJ, VGK does not hedge its currency risk. This fund weights by market cap and includes stocks in Switzerland and the United Kingdom.

	ETFInvestor Newsletter
	Want to read more about ETF investing? Subscribe to Morningstar ETFInvestor for fresh ideas for income and total return plus a bird's-eye view of valuations around the globe, portfolio construction advice, and data on the biggest and most popular ETFs.	One-Year Digital Subscription 12 Issues | $189 Premium Members: $179 Easy Checkout

Disclosure: Morningstar, Inc.’s Investment Management division licenses indexes to financial institutions as the tracking indexes for investable products, such as exchange-traded funds, sponsored by the financial institution. The license fee for such use is paid by the sponsoring financial institution based mainly on the total assets of the investable product. Please click here for a list of investable products that track or have tracked a Morningstar index. Neither Morningstar, Inc. nor its investment management division markets, sells, or makes any representations regarding the advisability of investing in any investable product that tracks a Morningstar index.