5 Alternative Strategies for Investing in Europe
Looking Beyond VGK and IEV for Exposure to Europe
Most investors look towards the largest and most liquid exchange-traded funds (ETFs) when making international investments. In Europe, the Vanguard FTSE Europe ETF (VGK) and the iShares Europe ETF (IEV) account for most assets under management. The problem is that these large funds may pigeon-hole investors into overly broad holdings that may not offer the best risk-adjusted returns for their portfolios.
In this article, we will look outside of the box at five alternative strategies that international investors can employ when investing in Europe.
Why Invest in Alternatives?
The largest European ETFs offer investors broad exposure to a plethora of different sectors across many different countries. If you’re looking to instantly add ‘Europe’ to a portfolio, these funds may be the easiest way to accomplish those goals with a single trade.
The problem with these large funds is that they’re weighted by market capitalization. In other words, you are purchasing more of the largest companies and less of the smallest companies. This may seem like a logical approach until companies start becoming overvalued. If you’re investing purely based on size, you’ll end up acquiring more and more stock in companies as they become overvalued — the opposite of you’d ought to be doing.
When it comes to pan-European funds, investors gain overweight exposure to the largest countries rather than equal exposure to all countries. The Vanguard FTSE Europe ETF (VGK), for example, holds a 25 percent stake in the United Kingdom compared to just 5 percent in Spain and 4 percent in Italy. A crisis impacting the United Kingdom in particular — such as the ‘Brexit’ — could, therefore, have a big impact on the portfolio even though the UK is only a small part of geographical Europe.
Most large European funds also avoid hedging against currency movements. In Europe, where pounds, euros, kronas, and francs all change relative to the U.S. dollar, the impact of a currency can be rather extreme. These currency risks can become a headache for investors if European companies post strong profits but the euro or other currencies decline against the U.S. dollar, which means that the absolute returns may be reduced.
Alternative ETFs for Investing in Europe
The good news is that there are many different European ETFs that utilize strategies other than market capitalization weighting. In general, these funds are referred to as ‘smart beta’ funds since they combine active management strategies with passive index investing. Investors may want to consider these different funds and strategies as an alternative to traditional market capitalization-weighted funds that tend to attract the most attention.
1. Hedge Against Currency Risk
Currency risk can have a significant impact on the returns of international investments. For example, European stocks could enjoy a health 10 percent growth rate during a given quarter, but a 5 percent decline in the euro versus the dollar over the timeframe means that U.S. investors would only see 5 percent of the 10 percent gain after conversion back into dollars. Many new ETFs have sought to hedge these risks to offer investors pure-play exposure to company performance.
The Wisdom Tree European Hedged Equity ETF (HEDJ) is a great example of a currency hedged European ETF that offers investors a pure-play option. Using derivatives, the fund makes up any difference in a foreign currency’s performance to offset the impact of conversion. The downside is that investors could miss out on favorable conversion rates and have less overall diversification given the lack of exposure to foreign currencies.
2. Consider Smart-Beta Funds
Smart beta funds have become a popular way to combine active investing strategies with a passive indexing methodology. Since the terms are so vague, there are literally thousands of different strategies employed by these funds. But the basic idea is to come up with a passive strategy for weighting stocks in an index other than by market capitalization. These strategies can be fundamentally-driven, technically-driven, or a combination of the two.
The First Trust Europe AlphaDEX ETF (FEP) is a European-focused smart-beta fund that uses price appreciation, revenue growth, book value, cash flow, return on assets, and several other metrics to weight an index of European stocks. The fund aims to outperform standard indexes while more closely meeting investors’ objectives when it comes to their portfolios, such as avoiding overvalued stocks or purchasing value stocks.
3. Add Small Cap Exposure
Most investors have small-cap exposure in their domestic portfolios, but international small caps are less common. But surprisingly, international small caps share many of the same benefits as their domestic counterparts, such as faster growing revenue and earnings. European small cap stocks also offer greater exposure to European consumers than many multinational companies that just happen to be domiciled in Europe.
The iShares MSCI Europe Small-Cap ETF (IEUS) is a great example of a European small cap fund that investors may want to consider to add exposure to the asset class. While the fund is still weighted by market capitalization (with a ceiling) it offers better exposure to smaller companies than market cap weighted funds with no ceiling. The fund may also help improve diversification since it’s less correlated with global markets.
4. Consider Dividend-Focused Funds
Retirement investors or investors seeking high-quality companies may be drawn to dividend-paying stocks. While many American companies pay the same dividend each quarter, European companies often pay a set percentage of their profits twice per year. This means that investors can see their dividend amounts automatically increase as a company’s profits increase — although they may also decrease if profits decline.
The First Trust STOXX European Select Dividend ETF (FDD) offers exposure to European equities with high dividend yields. While the fund may hold primarily large-cap companies, as is the case with market capitalization weighted funds, the holdings are weighted by dividend payouts rather than size. As of April 2017, the fund pays an attractive 4 percent dividend yield compared to just over 3 percent for the Vanguard FTSE Europe ETF (VGK).
5. Reduce Volatility With Low-Vol Funds
Europe has become a risky region of the world when it comes to international investing with the ‘Brexit’ and rising anti-euro tide. As a result, many investors may want to reduce their exposure to stocks that tend to experience wild swings. Fortunately, low volatility funds — or low vol funds — are focused on stocks that exhibit less volatility. Investing in these funds can help smooth out returns and make investing a lot less stressful.
The iShares MSCI Europe Minimum Volatility ETF (EUMV) weights stocks based on their volatility while giving low volatility stocks a greater percentage of the portfolio. As of April 2017, the Vanguard FTSE Europe ETF (VGK) had a beta coefficient of 1.21 percent — suggesting it was 21 percent more volatile than the S&P 500. The EUMV invests in less volatile sectors like defensive consumer staples and utilities to provide less volatility than VGK.
The Bottom Line
Most investors look towards the largest and most liquid exchange-traded funds (ETFs) when making international investments. But, doing so could pigeon-hole them into buying only large multi-national companies without true exposure to Europe. The five strategies outlined in this article can help you expand your horizons and invest in pure-plays that provide greater exposure, better diversification, and perhaps better risk-adjusted returns.