Shrinking Japan GDP Shifts ETF Outlook

August 13, 2014

Currency-hedged Japan ETFs are facing head winds as growth slows, but that’s not the whole story.

Japan’s slowing economic growth is hurting investment returns for those betting on the world’s No. 3 economy, and investors seem to be fine-tuning their approach. They are pulling out of the market’s most popular currency-hedged ETF strategy while plowing money into ETFs that make the dollar-yen cross part of fund returns.

Today’s report showing sharply negative growth in the second quarter shows why Japan investment returns have turned negative this year after 2013’s impressive 57 percent gain for the Nikkei 225. The Nikkei is down 4.5 percent this year.

New taxes are denting economic growth, though those have been expected as part of “Abenomics,” the country’s overall economic overhaul. The government there said today that GDP growth turned negative in the second quarter to the tune of -6.8 percent—worse even than the first quarter of 2011, which included the devastating earthquake-tsunami and nuclear disaster in March of that year.

As noted, ETF investors haven’t abandoned the Land of the Rising Sun, but they do seem to be fine-tuning their approach.

The WisdomTree Japan Hedged Equity Fund (DXJ | B-61), 2013’s ETF of the year, has had outflows in 2014 of about $2.3 billion, while the iShares MSCI Japan ETF (EWJ | B-97) has had inflows of $1.1 billion, according to ETF.com’s data screener.

Also, the nearly $10 billion DXJ has fallen 1.4 percent this year, while the close-to $15 billion EWJ has lost 0.92 percent—with much of the difference linked to the currency cross. Year-to-date, the yen has gained about 2.5 percent against the dollar after dropping some 20 percent last year. Last year’s weakening yen was a big reason DXJ was such a hit, in terms of both inflows and returns.

“People are starting to realize that maybe the yen isn’t going to continue tanking this year, and EWJ has outperformed DXJ,” said Dennis Hudachek, senior ETF analyst at ETF.com. “That’s why people are moving their money into EWJ and out of DXJ.”

Abenomics—Prime Minister Shinzo Abe’s three-part economic reform plan that includes quantitative easing, fiscal stimulus and structural reforms to the world’s No. 3 economy—was a hit last year. Abe unveiled the first two “arrows” last year. But the third arrow involving tax increases appears to be creating head winds.

The question ahead is whether this new consumption tax will create a long-term drag on the economy, or, conversely, if the taxes will help improve Japan’s fiscal imbalance enough to create new tail winds. After all, Japan is home to plenty of super-successful global brands like Honda, Mitsubishi, Toyota and even the somewhat-faded Sony.

XJ-DBJP_EWJ_2014_YTD_Returns

Chart courtesy of StockCharts.com

Notwithstanding the challenges that the currency-hedged fund DXJ is up against this year, ETF.com’s Hudachek reckons it may make more sense to put on a currency-hedged position in Japan. He argued that the case is starting to build for more quantitative easing from the Bank of Japan sometime next year, as the latest GDP report may be suggesting.

Investors looking for Japan equities exposure via hedged or unhedged vehicles can get it using the following ETFs:

 

 

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