By
Casey
Smith
:
Buy and hold investors should always focus on long term
healthy asset classes. In regards to investing in Europe, the key
question is whether or not Europe will be a financially healthy
asset class over the next ten years.
With the onset of the European debt crisis, Eurozone nations
pose a significant risk due to political uncertainty. Political
leaders continue to avoid solutions aimed at root causes, making
future investing in Eurozone companies unsuitable.
So what choices do investors have with this bleak outlook?
European investment risk may be reduced by investing away from
European Union nations, or by remaining invested but hedging
currency exposure.
Featured below are two strategies that highlight solutions for
investing passively in European and international markets, while
protecting portfolios against the increased systematic risks of
the European continent and falling currencies.
Strategy One - Separating Asset Classes
In recent months, the European Union governments have
developed special risks that have not been realized to the same
extent among other international developed nations, such as
Switzerland, Great Britain, Canada, Australia, and Singapore.
Considering the international developed category in less-broad
terms when modeling and building portfolios may allow for more
efficient allocations.
(click to enlarge)
In market environments when a falling US Dollar is the main
concern, investing as broadly as possible into the international
market is rewarded when lower correlations lower the risk.
However, in an environment when a rising dollar becomes a main
concern, there are benefits to separating international
investments so that each can be studied for its effect against a
rising dollar. In this current environment we can also diversify
political risk by allocating a larger percentage of our
international allocation to non-european countries.
Which ETFs?
For the European space, which accounts for about 25% of the
world's market capitalization, the iShares S&P Europe 350
Index, IEV, is a solid choice. The fund has 50% non-eurozone
investments; 37% and 14% of the ETF are invested in British and
Swiss companies, respectively. Morningstar reports that currency
has given the US investor the main boost in returns over the last
10 years - 6% versus 2% in local currency returns. Morningstar
also reports that this ETF has had a 91% correlation to the
S&P 500 over the last 10 years.
A comparable fund is the cheaper Vanguard MSCI Europe ETF,
VGK, with an expense ratio of 0.14% compared to iShare's IEV's
0.60%. Also, Morningstar reports that VGK has a yield of 4%, but
20-30% of those dividends are not considered qualified,
potentially causing the ETF extra tax expenses. IEV, however, has
had 100% qualified dividends over the last two years with a yield
of 3%.
(click to enlarge)
The Non-Europe Asset Class
To represent the asset class of non-european, international
developed countries (which are mainly Asian markets), the
Vanguard MSCI Pacific ETF, VPL, is a preferred choice with
limited competition in the ETF space. Over the last 10 years,
according to Morningstar, VPL has had a 70% correlation to the
S&P 500, though it is mainly caused by its 60% holding in
Japanese companies (Japan has its own economic concerns and major
national debt issues). Over the last 3 years, currency has given
this fund a 10% annualized boost for US investors against local
currency investors. Yields are around 3% according to
Morningstar.
(click to enlarge)
Strategy Two - Hedging Against The Euro
The WisdomTree International Hedged Equity Fund, HEDJ, is an
ETF giving an alternative perspective on International markets.
Through hedging the foreign currencies against the US Dollar,
HEDJ, gives investment access to international developed markets
while neutralizing currency fluctuations.
The ETF and index seek to give exposure to Europe,
Australasia, and the Far East (EAFE) while aiming to minimize
currency fluctuation in the ETF relative to the US dollar. This
fund can be compared to a local currency investment, benefiting
the US investor when the US dollar rises and hurting returns when
the US dollar falls on a relative basis against foreign
investments included in the ETF.HEDJ appears to be a good match
against iShares MSCI EAFE Index Fund (
EFA
) for a
currency hedging strategy.
The above ETFs compare fairly closely to covering similar
countries, though HEDJ seems to be slightly more diversified and
carries less of the slow growth economy of Japan.
Rising Dollar
The chart below compares a Euro/USD index against EFA and
HEDJ. As the Euro/USD began to sink in August 2011, both EFA and
HEDJ dropped nearly 15% (signifying the start to the European
Debt Crisis). But as the weakened Euro fell against the already
weak dollar, HEDJ allowed for much more upswing during the
bailout talks in the first quarter of 2012.
(click to enlarge)
The above graph shows a perfect scenario where a currency
hedged ETF works well. However, below, a March 2012 graph
comparing the same ETFs and currency index shows that having a
currency hedged fund does not protect in any way against loss in
the underlying stocks.
(click to enlarge)
An exchange-traded fund like HEDJ is extremely useful for a
specific market outlook - a rising dollar against currencies
represented in the index. Making long-term tactical decisions
such as to limit currency exposure can be done as a conservative
approach to international investing. Also, since this fund
closely matches asset classes found in EFA, a simple adjustment
can be made by switching between an MSCI EAFE Index and HEDJ,
allowing portfolio allocations to the international developed
asset class to be maintained.
Choosing Strategies
If you are not willing to make a currency play, simply
reducing your Europe allocation would lower your political risk.
Reallocating the reduced EFA can also be challenging. Perhaps
taking the approach in Strategy One, reallocating to global real
estate or incorporating a US large cap high dividend play would
be good options. In the long term just holding Europe without a
strategy does not seem like it will work out well.
*All data comes from Morningstar Advisor Workstation and
charts have been taken from Yahoo Finance. All opinions are the
analyst's unless stated otherwise. Kyle Waller, Research Analyst
and Mitchell Williams, Intern Research Analyst contributed to
this article.
Disclosure:
I am long
EFA
.
See also
EZchip Semiconductor's CEO Discusses Q2 2012
Results - Earnings Call Transcript
on seekingalpha.com