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Dennis Hudachek Analyst Blogs

A Cautionary Tale About DXJ

Related ETFs: EWJ | DXJ | FJP | DBJP

I’ve been one of the biggest cheerleaders for the WisdomTree Japan Hedged Equity Fund (NYSEArca: DXJ) for some time now. Still, the current euphoria around “Abenomics” and the Nikkei’s massive returns on the back of a plunging yen in a short few months is starting to make me feel a bit cautious.

I’m increasingly seeing only a one-sided optimistic view on DXJ, almost as if it’s a sure bet. So, I think it’s only fitting that we cover some of the potential pitfalls of Japan, and by extension, DXJ. After all, considering that the crowd could be wrong is a critical step in your investment decision-making.

I want to be clear that I’m not calling an end to the DXJ party that has given investors more than 40 percent returns since mid-November 2012. DXJ and Japanese equities could very well rally hard for many more months.

Still, I wonder how much influence foreign institutions and hedge funds have had in the recent rally. I also think of some serious longer-term issues in Japan, including unfavorable demographics, its dependence on exports, the demoralized state of its consumer base and that the government’s mountain of debt may weigh heavily.

Investors piling into DXJ at this juncture to chase returns should think about whether they’re trading on momentum, or investing for the long haul, and remind themselves that there’s no such investment as a sure thing.

First, A Bit Of Background …

DXJ has been one of the hottest ETFs of 2013, raking in more than $3.7 billion in asset flows and returning more than 19 percent year-to-date.

Since early November 2012, when DXJ was a $530 million fund, it’s grown almost 1000 percent and is now a $5.4 billion fund. This puts DXJ within arm's reach of the $7 billion iShares MSCI Japan Index Fund (NYSEArca: EWJ) $7 billion.

Of course, DXJ’s ballooning assets are not only due to its massive inflows, but also to its surging net asset value.

The reasons for DXJ’s sudden superstar status are probably well known by now, so I won’t dig into it in detail. In a nutshell, DXJ’s massive outperformance is predominantly attributed to its currency-hedged feature.

Kudos to the folks at WisdomTree for being early birds in spotting the negative correlation between the yen and Japanese equities. They tweaked their existing Japan ETF strategy in 2010 to hedge out the yen exposure.

Now The Potential Pitfalls

It shouldn’t come as a surprise to see a sharp relief rally in Japanese equities now that the formerly ultra-strong yen—which was choking off the profits of some of Japan’s largest multinational companies—is falling hard from all-time highs.

Still, the yen’s depreciation has come a long way in a few short months in the aftermath of Shinzo Abe’s election. Since mid-November, the yen has plummeted almost 20 percent. I think most investors, including Japanese officials, probably weren’t expecting such a large plunge in such a short time frame.




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