Japanese equities have rallied strongly over the past three months, with the widely followed Nikkei 225 adding an impressive 20.6% in local-currency terms. However, Japan-linked equity ETFs haven’t necessarily matched this stellar performance. The NYSE-listed Maxis Nikkei 225 Index ETF (NKY), for example, managed only 7.4% over this period, while the $5.2 billion iShares MSCI Japan ETF (EWJ), also listed on the NYSE, returned 7.5%.
As the Japanese yen has weakened, dollar-hedged ETFs have outperformed their unhedged counterparts (see chart below).
The reason for this divergence is the impact of currency movements. In the past three months the US dollar has strengthened against the Japanese yen by about 12%, resulting in a significant drag on the performance of unhedged ETFs, such as the Maxis and iShares funds mentioned above.
By contrast, dollar-hedged ETFs, which hedge currency fluctuations between the value of the yen to the dollar, have kept in sync. The db-X MSCI Japan Currency-Hedged Equity ETF (DBJP) and the WisdomTree Japan Hedged Equity ETF (DXJ), for example, both listed on the NYSE, have posted in-line returns of 21.3% and 19.5% respectively.
This stark divergence in performance demonstrates how important it is to take into consideration the impact of potential currency movements on a portfolio holding international stocks. In more stable times, when global imbalances are less pronounced, currency hedging is not so critical. But in the current environment, when markets are in a state of flux, planning for possible currency realignments is vital. This is particularly true of Japan today, where a new administration appears determined to stimulate the country’s stagnant economy – with knock-on effects for the yen.
A decisive victory for Shinzo Abe and his Liberal Democratic Party in December’s election has strengthened calls for aggressive monetary policies to reflate Japan’s economy, which has been weighed down by an overvalued yen, excessive debt and chronic deflation. Policies being mooted in the Diet (Japan’s parliament) include unlimited quantitative easing, an increase in the inflation target, and zero or negative interest rates.
Crucially for foreign investors, these measures would weaken the yen, potentially resulting in losses for unhedged positions. In this kind of scenario, when the yen is weakening relative to an investor’s base currency, currency-hedged products come into their own as they deliver higher returns than an equivalent non-currency hedged fund.
If this scenario plays out and the yen weakens further, Japan’s export-oriented economy would undoubtedly benefit. This, in turn, would likely translate into positive returns for the Japanese equity market, which is dominated by exporters such as Toyota, Honda and Canon.
This is a view shared by Jeremy Schwartz, Director of Research at WisdomTree, the firm behind the WisdomTree Japan Hedged Equity ETF (DXJ), which recently surpassed $1 billion in assets: “I believe Japan’s stocks are attractively priced, and many are optimistic about recently elected Prime Minister Shinzo Abe’s intention to pull Japan out of deflation and correct the strong yen which has punished the country’s exporters. By hedging its exposure to the yen, DXJ offers a way to more fully access the return potential of Japanese equities in a weakening yen environment.”
UK and European investors looking to access Japanese equities, but who are concerned about fluctuations in sterling versus yen and the euro versus yen, also have a range of currency-hedged ETFs at their disposal.
There are two funds aimed at sterling-based investors: the db X-trackers MSCI Japan GBP Hedged TRN Index ETF (XMJG) and the iShares MSCI Japan Monthly GBP Hedged ETF (IJPH), both of which track the broad-based MSCI Japan and are listed on the London Stock Exchange (LSE).
For euro-based investors there are four options: the Amundi ETF Topix EUR Hedged Daily (TPXH) and the RBS Market Access Topix EUR Hedged Index ETF (M9SW), which track the Topix; and the iShares MSCI Japan Monthly EUR Hedged ETF (IJPE) and db X-trackers MSCI Japan EUR Hedged TRN Index ETF (XMK9), which track the MSCI Japan. The Amundi fund is listed on the NYSE Euronext; the RBS fund is listed on the Deutsche Börse (Xetra); while the iShares fund is cross listed on the LSE, Borsa Italiana, Deutsche Börse (Xetra), NYSE Euronext Amsterdam and SIX Swiss Exchange.
Three-month performance: iShares MSCI Japan ETF (EWJ) versus db-X MSCI Japan Currency-Hedged Equity ETF (DBJP)