Hedged Japan ETFs Set For Big Cap Gains

Investors in some of the largest currency-hedged Japan ETFs might be shocked when they wake up this Friday morning to see their funds’ net asset values (NAV) gap down by 8-9 percent, as their shares go ex-dividend.

That’s because the $12.8 billion WisdomTree Japan Hedged Equity ETF (DXJ | B-66) and the $662 million Deutsche X-trackers MSCI Japan Hedged Equity ETF (DBJP | B-71) are both set to make big capital gains distributions the following Friday on Dec 26.

DXJ is estimated to pay out $1.5823 a share in short-term gains and $2.61358 in long-term gains, which, combined, amounts to about 8 percent of the fund’s NAV as of Dec. 15. DBJP is estimated to pay $3.60 a share in ordinary income, which amounts to about 9 percent of its NAV as of Dec. 15.

But before getting into a tizzy over this, it’s important to understand the reasons behind these distributions. Also, DXJ and DBJP’s distributions will be taxed differently, which only adds complexity to an already-interesting story.

Forward-Currency-Contract Gains

First and foremost, investors need to understand that the majority of these distributions are not from dividends—DXJ and DBJP show “portfolio” yields of 2.50 and 2 percent, respectively—but from gains made in forward-currency contracts used to hedge-out yen exposure.

To hedge out the “long” currency exposure that inherently comes with holding local stocks (in this case, Japanese stocks), the ETF simply overlays its equity position with “short” forward-currency contracts.

The ETFs enter into monthly forward contracts, and the notional value of the currency forwards are rebalanced monthly. With the yen plunging more than 11 percent year-to-date, the ETFs are sitting on big gains from those “short” yen-forward contracts, most of which need to be distributed.

Not helping matters, most of the yen’s fall occurred toward the end of the year, with the Bank of Japan surprising markets with an additional dose of stimulus announced on Oct. 31. This gave the ETFs less time to make adjustments to “wash” these gains out of the fund by year-end.

Taxation Differences

Both funds use monthly forward contracts to hedge-out yen exposure. Still, DXJ differs in how its gains will be taxed compared with DBJP.

DXJ’s forward-currency contract gains are taxed at the “60/40” rate, similar to the way futures contacts are taxed. This means 60 percent of its currency gains is taxed at the long-term rate, while 40 percent is taxed at the short-term rate.

So, investors in the highest tax brackets are paying a maximum “blended” rate of 27.84 percent for these currency gains (not including other rates that might apply, such as the Medicare surcharge tax).

According to WisdomTree, DXJ is eligible for the 60/40 rate because it elects to treat its gains on its forward contracts as capital, as opposed to ordinary income.

DBJP’s gains are all set to be ordinary income distributions, which get the maximum of 39.60 percent rate for the highest-tax-bracket investors (for more details on taxation, see our 2014 Tax Guide).

The Case For Being Yen-Hedged

Even with these distributions, investors who held currency-hedged Japan ETFs throughout 2014 are far better off than those who held unhedged ETFs.

Just look at the differences in year-to-date returns of DXJ and DBJP compared with those of the leading unhedged Japan ETF, the $15 billion iShares MSCI Japan ETF (EWJ | B-98).

Chart courtesy of StockCharts.com

We’re talking about differences of 10-12 percentage points. I’m sure most investors would take paying taxes on capitals gains in an outperforming ETF over being invested in a laggard by 10-plus percentage points in returns.

Still, these distributions are clearly not ideal for newer investors in DXJ or DBJP.

Framing The Currency-Hedging Decision

Going forward, the focus on deciding whether to go hedged or unhedged should still rest more on your view of the Japanese yen, rather than potential distributions from currency gains, which are simply a byproduct of the way these ETFs are structured.

Also keep in mind that hedged ETFs don’t actually take a net-notional short position in the currency. They simply neutralize the exposure, or take the currency equation out of the fund.

So, contrary to what many investors think, you don’t necessarily have to have a bearish view on the yen to invest in a yen-hedged ETF. You might simply be neutral on the yen and just want purer equity exposure.

One way or another, understanding how these funds work is important so that you’re not caught off guard when they pay out enormous distributions.

At the time this article was written, the author held no positions in the securities mentioned. Contact Dennis Hudachek at [email protected], or follow him on Twitter @Dennis_Hudachek.