Hedge the yen to protect Japan equity gains

U.S. investors are shifting into currency-hedged exchange-traded funds that focus on Japanese equities to limit losses from a weak yen. The yen has traded near its lowest level in about 40 years. Hedged funds such as WisdomTree’s Japan Hedged Equity Fund (DXJ) have outperformed the unhedged iShares MSCI Japan ETF (EWJ). The iShares Currency Hedged MSCI Japan ETF (HEWJ) has also beaten EWJ since 2014.

The yen’s decline reflects a widening gap in nominal interest rates and other market pressures. The U.S. Federal Reserve’s benchmark rate has been around 3.5% to 3.75%, while the Bank of Japan’s policy rate remains near 1%. The interest-rate gap has encouraged carry trades, where investors borrow low-yen funds to buy higher-yielding assets. Rising oil costs have increased demand for dollars to pay for imports, which has required selling yen and added downward pressure.

A weaker yen increases reported profits for Japanese exporters because their goods become cheaper abroad and overseas revenue converts into more yen. For U.S. investors holding unhedged Japanese stocks, a falling yen reduces returns when those local currency gains are converted back into dollars.

Currency-hedged ETFs use forward foreign-exchange contracts to remove short-term yen moves from dollar returns. WisdomTree’s DXJ applies a static one-month forward hedge while selecting dividend-paying companies with an exporter tilt. Hedged funds aim to separate the performance of local equities from fluctuations in the exchange rate so dollar returns reflect corporate earnings and stock price moves rather than FX swings.

Since its 2006 launch, DXJ has outpaced EWJ by more than 160 percentage points, according to fund performance data. The hedged iShares ETF (HEWJ) has also outperformed EWJ since its inception in 2014. Fund managers and providers cite those results when explaining investor interest in hedged products during a persistent yen decline.

WisdomTree research reports that unhedged currency exposure increased portfolio volatility by about 25% over 10- to 15-year periods compared with local-equity returns. The firm also notes that the current interest-rate environment produces a positive carry on hedging, estimating the annualized carry to be roughly 1% above its historical average, which can reduce net hedging costs.

Corporate governance and market-structure changes in Japan have accompanied the equity rally. The Tokyo Stock Exchange has pressed companies with low price-to-book ratios to disclose plans to improve value. Some firms have raised dividends and buybacks. Berkshire Hathaway increased stakes in several major Japanese trading houses. Japan’s forward price-to-earnings multiples are lower than many peers, a factor some investors cite when allocating to the market.

Hedged equity ETFs are available for other regions as well. Funds that apply currency hedges to regional or country exposures allow U.S. investors to isolate local equity returns from exchange-rate moves. The practical effect for U.S. holders is that a weak yen tends to boost exporter earnings but can cut dollar returns for unhedged positions; hedged ETFs remove those direct FX effects on dollar performance.

Jeremy Schwartz, WisdomTree’s global chief investment officer, noted: “Let me establish one baseline which I think people don’t have: they bet too much against the dollar forever.”