European equities and the corresponding exchange-traded funds (ETFs) are trouncing their U.S. counterparts this year. That sentiment extends to smaller stocks, as European small caps are among the world's best performers this year, underscoring the notion that domestic economies are improving throughout the Eurozone. The WisdomTree Europe Hedged SmallCap Equity Fund (EUSC) is up 18.3 percent year to date, beating the Russell 2000 Index by a better than three-to-one margin. Amid the combination of improving Eurozone economic data and another interest rate hike by the Federal Reserve, U.S. investors may want to consider the advantages of a European small-cap strategy that hedges the dollar/euro currency pair.

While the euro has been a surprise among developed market currencies this year, the dollar has been a dud. A case can be made that those roles should be reversed, particularly with interest rates rising and macro events still looming to potentially challenge the euro. "Greece hasn't been figured out. Italian banks haven't been figured out," said WisdomTree in a note. "The risks of Brexit's ramifications should be even more apparent after the hung Parliament result of last week's election. The European Central Bank (ECB) is still printing money aggressively, the deposit rate is still -0.40 percent and ECB President Mario Draghi continued his dovish stance in comments after last week's ECB monetary policy meeting." (See also: Central Banks' $13 Trillion Problem.)

Remember that EUSC is essentially the small-cap answer to the popular WisdomTree Europe Hedged Equity Fund (HEDJ), and both ETFs have traded sharply higher, while the CurrencyShares Euro Trust (FXE) is up 6.2 percent. Looked at another way, even if the common currency modestly dips against the greenback, EUSC and HEDJ could deliver more upside. (See also: Are Currency Hedged ETFs a Good Idea?)

Italian political risk and the fragility of that country's banking system are issues to consider with EUSC because the ETF allocates 21.5 percent of its weight to Italy, which is the Eurozone's third largest economy. However, France, Germany and Spain, three of the region's best performing equity markets this year, combine for almost half of EUSC's roster. 

"The long-term fundamental and valuation case for Europe is strong, but political and geopolitical surprises always have the potential to cloud the short-term picture," said WisdomTree. "Whether it is from a currency-hedged starting point to focus on the valuation of stocks while neutralizing the impact of currency or the more local domestic-focused position, WisdomTree offers unique tools to access a recovery in European markets."

Since inception in early 2015, the WisdomTree Europe Hedged SmallCap Equity Index, EUSC's underlying index, has outperformed the MSCI EMU Small Cap Index. EUSC's index has a dividend yield of 3.2 percent, triple that which is found on the Russell 2000. (See also: A Compelling Catalyst for Europe ETFs.)


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