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DXJ--Best ETF to Play the Japan Rally

DXJ EWJ

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Japanese stocks continued their advance after the recently concluded Group of 20 (G-20) summit held in Moscow. Not only did it hint towards scrapping the possibility of the notorious currency wars, but it also somewhat ignored the ultra loose Japanese monetary policy designed to boost the economy.

The Japanese economy has witnessed a number of changes in terms of leadership as well as policy enactments over the past few months. The newly elected Prime Minister, seems determined to boost the Japanese economy by proactive measures such as an open ended monetary easing program.

The economy has been a victim of deflation and almost zero growth over a long time. But the recent Bank of Japan (BoJ) measures, under the new leadership, aim to continue the monetary easing until the inflation reaches 2%. This is somewhat similar to the strategy adopted by the Federal Reserve, which had earlier planned to continue with their quantitative easing till signs emerged of unemployment below the 6.5% level and inflation not over 2.5%. (Read Time for Inverse Bond ETFs?)

Like any other monetary easing measures induced by a central bank, the primary motive is to stimulate the economy. However, the measures also aim at encouraging the investors to take on greater risk. This is in order to boost the equity markets. And it seems that the Bank of Japan has already succeeded in one of these parameters i.e. bringing back the ‘risk on’ sentiment in the capital markets.

Since the beginning of November, the Japanese markets were in anticipation of a major shift in leadership and policies. And since that time the benchmark Japanese Index, the Nikkei 225 has rallied around 41.23%.

While very little of this massive gain can be attributed to the fundamental picture of the Japanese economy, one cannot help but imagine that this surely was a central bank induced rally. Whatever be the case, investors who could foresee this are sitting over a fair amount of profit. (Read Is the China ETF Ready to Soar?).

Furthermore, thanks to the monetary easing, the Japanese Yen has lost about 15.31% versus the U.S dollars. While this may not seem much of a problem to the investors holding yen denominated assets in Japan, it surely does mean a lot to the U.S. investors.

Considering the above, the effective rate of return for the U.S. investors would have been around 25.92%. This is ascertained by subtracting the Yen depreciation from the rally in the Nikkei 225 (i.e. 41.23%-15.31%). Therefore we see that yen depreciation has reduced the profit substantially for the American investors.

In the light of this we would like to highlight two ETFs which are easy as well as cost effective ways to gain exposure in the Japanese equity markets. The iShares MSCI Japan ETF (EWJ - ETF report) and the WisdomTree Japan Hedged Equity ETF (DXJ - ETF report). Both these ETFs seek to provide exposure in the Japanese equity market. However, there is a big difference between these two ETFs. (See Three Surging ETFs with Strong Momentum)

DXJ seeks to hedge away any negative (or positive) currency movement that the Japanese yen exhibits versus the U.S. dollar. It does this by utilizing various currency swap agreements. As we have discussed in this article as well as other articles, currency risk is one of the foremost factors that investors must consider before taking any international investment decisions (read The Key to International ETF Investing).

 

The above chart represents the comparative returns of EWJ with DXJ on a one year look. Notice how the almost similar returns pattern of the two ETFs diverges from end November onwards. The currency hedged ETF DXJ starts significantly outperforming its non hedged counterpart EWJ, although both these products have witnessed a surge since the November levels.

This is the time when Japanese equity markets began to surge and the Yen began to depreciate versus U.S. dollars. And the disparity in returns clearly took place due to the weakening Yen which caused EWJ to significantly reduce its profit potential. But EWJ had earlier made a bullish pattern which hinted towards its surge. However, the surge would have been greater, had the Yen not depreciated as much as it did.

In fact in the past few months EWJ has returned around 18.56%, which is almost equal to the effective returns that we had earlier talked about in the first half of the article. However, for the same time period, DXJ has returned around 36.70% in terms of total returns. This highlights the impact that the Yen has had on the returns of the two ETFs in question.

What Lies Ahead?

While it is prudent to think that after such strong stock market rally and currency devaluation, a reversal is imminent. However, considering the BoJ’s plans, the 2% inflation level is still quite far. At the same time, a favorable G-20 meeting (for the Japanese of course), more monetary easing and devaluation seem to be the way to go. (See Do Large Cap ETFs Signal Trouble Ahead?)

However what will be interesting to see is whether the Japanese market will just be swayed away by the flood of liquidity (as it has thus far), or will macroeconomic fundamentals start weighing in. Either way, DXJ still seems to the ‘safer’ option for investors seeking a Japanese exposure going forward.

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