Can the Yen-Hedging Japan ETF Keep Obliterating EWJ?

by Daniel Putnam | February 14, 2013 11:33 am

If you’re among the many investors who keep your television turned to CNBC throughout the trading day, you’ve undoubtedly noticed the endless ads for WisdomTree Japan Hedged Equity Fund (NYSE:DXJ[1]). The fund offers exposure to Japanese equities like the larger iShares MSCI Japan Index Fund (NYSE:EWJ[2]), but it hedges out the impact of yen movements on performance.

Or, as the tagline in the ad says, it allows investors to “Take the yen out of Japan.”

This approach has paid off in a big way for DXJ investors in the past four-plus months. Since Oct. 1, the yen — as measured by the CurrencyShares Japanese Yen Trust ETF (NYSE:FXY[3]) — has plunged 16.7%, which is an extraordinary move for a currency in such a short period of time. This sharp downturn is reflected in the performance of the Japan ETFs: DXJ has rocketed to a return of 29.9%, blowing away the 11.1% gain of EWJ.

dxj13 Can the Yen Hedging Japan ETF Keep Obliterating EWJ?

This performance gap hasn’t been lost on investors. According to IndexUniverse.com, DXJ attracted more assets than any other ETF from Feb. 7-13, hauling in $842 million in new cash. In that same period, EWJ saw an outflow of $41 million.

The WisdomTree fund is in a unique position in that it has benefited from the falling yen in two ways. Not only has the currency’s decline boosted the fund’s relative performance vs. EWJ, but it also has provided a major boost to the fund’s underlying holdings by making exporters’ products more competitive in the foreign markets. Since mid-November, Toyota (NYSE:TM[4]) and Honda (NYSE:HMC[5]) are up 30% and 23%, respectively, and even the perennial dogs Sony (NYSE:SNE[6]) and Panasonic (NYSE:PC[7]) have managed to tack on 45% and 48%. DXJ has enabled investors to take advantage of this without suffering the drag on returns caused by the declining yen.

fxy1 Can the Yen Hedging Japan ETF Keep Obliterating EWJ?

On a longer-term basis, DXJ has a lot to recommend it. The primary reason for the weakness in the yen is that the Bank of Japan has pledged to print money until the country’s inflation rate hits 2%. Given that headline CPI has been negative for seven months running — not to mention that Japan hasn’t had positive inflation since 2008 — this 2% target essentially takes the concept of QE Infinity to another level. The chart below, from tradingeconomics.com, shows just how far away the 2% inflation target really is:

japan inflation cpi1 Can the Yen Hedging Japan ETF Keep Obliterating EWJ?

That’s not all. As most investors know, Japan faces a demographic time bomb in the form of its aging population. Worse, Standard & Poor’s projects Japan’s debt-to-GDP ratio to come in at 238% in 2013 — the worst in the world, and that includes Greece, Italy and the other European countries that dragged the region into its crisis. S&P projects that this ratio will exceed 250% by 2016.

These factors indicate that the yen could remain under pressure for years to come.

But at this point, investors need to question whether performance-chasing with DXJ is the right approach — particularly given the size of the herd that has rushed into this fund in the past week. While the WisdomTree fund has surged of late, a look at the five-year chart comparing the two ETFs shows that they tend to track fairly closely over the long-term — meaning investors who get into DXJ now after its phenomenal run are taking the risk that they’ll be on the wrong side of a mean reversion trade.

dxj24 Can the Yen Hedging Japan ETF Keep Obliterating EWJ?

The bottom line: Investors who want to play Japan for the long-term should strongly consider DXJ over EWJ. For now, however, it’s necessary to recognize just how much the yen has already moved — and the extent to which DXJ has outperformed — in the past few months.

As of this writing, Daniel Putnam did not hold a position in any of the aforementioned securities.

Endnotes:
  1. DXJ: http://studio-5.financialcontent.com/investplace/quote?Symbol=DXJ
  2. EWJ: http://studio-5.financialcontent.com/investplace/quote?Symbol=EWJ
  3. FXY: http://studio-5.financialcontent.com/investplace/quote?Symbol=FXY
  4. TM: http://studio-5.financialcontent.com/investplace/quote?Symbol=TM
  5. HMC: http://studio-5.financialcontent.com/investplace/quote?Symbol=HMC
  6. SNE: http://studio-5.financialcontent.com/investplace/quote?Symbol=SNE
  7. PC: http://studio-5.financialcontent.com/investplace/quote?Symbol=PC

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