In recent weeks, I’ve discussed increased US market volatility—some of which is due to eurozone uncertainty. Invesco PowerShares believes the long-term outlook for European stocks is favorable. The eurozone accounts for just over 17% of global GDP – second only to the United States – and the strength of the US dollar relative to the euro has made European exports more affordable in world markets. I expect a devalued euro, coupled with more stimulative monetary policy, to give a lift to European stocks well into 2016.
Near-term, however, investors in European equities may experience a bumpier ride.
Quantitative easing exacerbates currency risk
The European Monetary Union itself has generated headwinds to growth, due to inherent disparities between European Central Bank (ECB) policy goals and the divergent needs of member countries. A case in point is Greece, which requires a weaker currency than its peers to support tourism, but can’t get that with the euro. Additional overhangs include overstretched equity valuations and uncertainty about whether eurozone economies can maintain consistent growth rates.
To jump start the economy, the ECB has recently begun the process of quantitative easing. Policy makers in Brussels have slashed the refinancing rate – a rough equivalent to the US federal funds rate (the rate at which banks lend balances to each other overnight) – to the point of creating negative deposit rates throughout the eurozone. This has exacerbated foreign currency risks.
European equities historically volatile
Today’s currency concerns are just the latest chapter in the story of European volatility: European equities have generally demonstrated more volatility than US stocks over the past 10 years. As you can see from the chart below, the volatility of the MSCI EMU Index was 14% greater than that of the S&P 500 Index from 2003 through 2014 – and that’s with the EMU index denominated in euros. In US dollar terms, the MSCI EMU Index was 37% more volatile than the MSCI EMU local currency index over this same period, and 56% more volatile than the S&P 500.1
Sources: Bloomberg L.P., Dec. 31, 2014, World Bank, Dec. 16, 2014. Past performance is not a guarantee of future results. Investments cannot be made directly into an index.
A two-pronged approach to volatility and foreign currency risk
So how can one maintain exposure to the potential long-term growth of European markets, while buffering against volatility and currency risk? Investors facing this conundrum may wish to consider strategies that emphasize low volatility stocks and currency hedging.
This week, Invesco PowerShares introduced the PowerShares Europe Currency Hedged Low Volatility Portfolio (FXEU). FXEU uses a low volatility index methodology in concert with a foreign currency hedge.
Here’s how it works: FXEU tracks the S&P Eurozone Low Volatility USD Hedged Index. The 80 holdings in this index are weighted inversely to their volatility, so that stocks with the lowest volatility receive the highest weights. The portfolio is then hedged to the US dollar using one-month forward contracts.
FXEU provides a compelling exchange-traded fund solution for investors looking to help mitigate volatility and foreign currency risks, while capturing the growth potential of investing in European stocks.
1 Sources: Bloomberg, L.P., Dec. 31, 2014, World Bank, Dec. 16, 2014
More from Nick Kalivas on low volatility investing:
Low Volatility Investors Brace for Higher Interest Rates
Strong US Dollar, Seasonal Factors Contributing to Market Volatility
Important information
Volatility measures the amount of fluctuation in the price of a security or portfolio. Volatility was measured using standard deviation of returns.
The S&P 500® Index is an unmanaged index considered representative of the US stock market.
The S&P Eurozone Low Volatility USD Hedged Index measures the performance of the 80 least-volatile stocks in the S&P Eurozone BMI that trade in euros on eurozone-domiciled exchanges. The performance of these stocks is hedged against fluctuations of the U.S. dollar.
The MSCI EMU Index (European Economic and Monetary Union) captures large- and mid-cap representation across the 10 developed markets countries in the EMU.
The MSCI Hedged Indexes hedge each foreign currency in the parent index back to a “home” currency by selling each foreign currency forward at the one-month forward rate.
In general, equity values fluctuate, sometimes widely, in response to activities specific to the company as well as general market, economic and political conditions.
The risks of investing in securities of foreign issuers, including emerging market issuers, can include fluctuations in foreign currencies, political and economic instability, and foreign taxation issues. The dollar value of foreign investments will be affected by changes in the exchange rates between the dollar and the currencies in which those investments are traded.
Many countries in the European Union are susceptible to high economic risks associated with high levels of debt, notably due to investments in sovereign debts of European countries such as Greece, Italy and Spain.
FXEU risks:
There are risks involved with investing in ETFs, including possible loss of money. Shares are not actively managed and are subject to risks similar to those of stocks, including those regarding short selling and margin maintenance requirements. Ordinary brokerage commissions apply. The Fund’s return may not match the return of the Underlying Index. The Fund is subject to certain other risks. Please see the current prospectus for more information regarding the risk associated with an investment in the Fund.
The Fund may invest in foreign markets and because foreign exchanges may be open on days when the Fund does not price its shares, the value of the non-US securities in the Fund’s portfolio my change on days when you will not be able to purchase or sell your shares. The dollar value of foreign investments will be affected by changes in the exchange rates between the dollar and the currencies in which those investments are traded.
Investments focused in a particular industry or sector are subject to greater risk, and are more greatly impacted by market volatility, than more diversified investments.
Derivatives may be more volatile and less liquid than traditional investments and are subject to market, interest rate, credit, leverage, counterparty and management risks. An investment in a derivative could lose more than the cash amount invested.
Currency hedging can reduce or eliminate losses or gains and can also be subject to imperfect matching between the derivative and its reference asset. There is no assurance the Fund’s hedging strategy will be effective. Some foreign currency forward contracts are less liquid, which may result in the Fund being unable to structure its hedging transactions as intended and may be unable to obtain sufficient liquidity in an underlying currency. As a result, the Fund’s hedging transactions may not successfully reduce the currency risk included in the Fund’s portfolio.
The Fund may hold illiquid securities that it may be unable to sell at the preferred time or price and could lose its entire investment in such securities.
The Fund is non-diversified and may experience greater volatility than a more diversified investment.
Shares are not individually redeemable and owners of the Shares may acquire those Shares from the Funds and tender those shares for redemption to the Funds in Creation Unit aggregations only, typically consisting of 50,000, 75,000, 100,000 or 200,000 Shares.
PowerShares® is a registered trademark of Invesco PowerShares Capital Management LLC (Invesco PowerShares). Invesco PowerShares and Invesco Distributors, Inc. are indirect, wholly owned subsidiaries of Invesco Ltd. Invesco Distributors, Inc. is the distributor of the PowerShares Exchange- Traded Fund Trust II.
