The Yen Carry Trade's Effect on ETFs

If you follow the stock market and didn’t know what a “carry trade” was a couple of weeks ago, you probably know now. 

This time around the massive amount of capital borrowing in low-interest rate Japanese yen, used to invest in higher-return investment, built up a wall of worry in some corners of Wall Street.  

Last Monday in Japan, and soon after around the globe, that Wall had a chunk taken out of it. Then just as suddenly, as if nothing had happened, the markets recovered some of the big dent from Monday’s global selloff.

So, what happens next, and how does it impact ETFs and folks who invest in them? $4.1 billion Wisdom Tree Japan Hedged Equity Fund (DXJ) is the one in the spotlight. It is not every day we can say that the third largest fund in a large ETF company (Wisdom Tree) is an ETF that invests in non-U.S. stocks and hedges the local currency. But that’s the case with DXJ.  

DXJ ETF's Surge

And since it strips out the impact of the yen on those local Japanese stocks, that has made DXJ a magnet for ETF investors seeking Japanese equity exposure. While the $14.7 billion iShares MSCI Japan ETF (EWJ) has piled on the assets, over the past three years, DXJ has outperformed EWJ: 76% to 2%.  

And we don’t have to look too far to find an ETF that essentially ties that huge performance gap together. It is an ETF that tracks the value of the yen, the $373 million Invesco CurrencyShares Japanese Yen (FXY). It is down 30% during that same three-year time frame.  

Japan, August, and the S&P 500

The markets came flying back last week, though it would be a stretch to say that this is the last we’ll see of the volatility. The 1987 crash was tied in part to Japan’s equity market. That infamous October event, in which the S&P 500 index fell more than 20% in a single day (a Monday, the same day last week that Japan’s stock market fell 11% in a day). But the seeds of that sudden halt to a bull market were sewn starting in August of that year. Last I checked that’s what month we are in now.  

U.S. investors and financial advisors likely spend more time on stocks, bonds, commodities and even cryptocurrency than they do tracking currencies. But suddenly, what was once a given (a weak, low-yielding Japanese bond market and the commensurate cheap currency) has a spotlight on it. The next few months will show us whether this was a one-day Japan “flash crash” or the start of a reversal of a very long trend.