Which Japan ETF For 2015?

Hedged equity ETFs—last year’s darlings—have had a rough year. Maybe not for long.

If we had to pick one story for 2013 in the ETF landscape, it would probably have to be the meteoric rise of hedged equity products, led by the WisdomTree Japan Hedged Equity ETF (DXJ | B-64). The introduction of Prime Minister Shinzo Abe’s fairly radical reforms were designed to tank the yen while at the same time boost a faltering Japanese economy.

The yen did indeed collapse to trade more than 100 to the dollar for the first time since 2008, and it brought DXJ—and the Deutsche X-Trackers MSCI Japan Hedged Equity ETF (DBJP) along for the ride.

In fact, if you got the call right anytime in 2012, the hedged Japan call was nearly one of those once-in-a-lifetime “aha!” trades. If you were really smart (or just really lucky) you even made the right call to be in the Deutsche product (which hedges the dirt-simple MSCI Japan index) instead of the more unique exporter-focused WisdomTree product.

The theory there is that the Japanese recovery would be driven not so much by Japanese products becoming cheap to the external markets (the DXJ approach) but by a grass-roots consumer class boom (the DBJP premise).

Alas, for most of 2014, it’s looked like neither strategy was going to work very well.

With the yen flatlined, or indeed strengthening, for much of this year, both approaches to hedging Japan failed to offer much in the way of performance, and at their worst, both actually lost you something around 13 percent for the year. Since then, we’ve seen a substantial rally in Japan (along with the rest of the world), but little movement in the yen.

Until now. Two things are going on.

First, currency traders have become increasingly bullish on the dollar. Yesterday’s Purchasing Manager Index surprise was the latest in a string of evidence that the U.S. economy may in fact be strong enough to withstand a little 2015 interest-rate action by the Fed. Any increase in interest rates is expected to be very strong for the dollar, and in the seesaw world of currencies, a strong dollar has to mean weakness in the major cross currencies—like the yen.

Second, Abe knows that the Japanese recovery is a bit on the rocks. The Japanese economy is in full-on recession, decreasing almost 7 percent annualized, according to the recent data, with inflation of just 1.3 percent and declining consumer spending.

This morning, Abe reshuffled his cabinet in a bid to get things moving again, and most economists are expecting another round of stimulus. Whether or not that makes for successful long-term growth in Japan, it will almost surely further devalue the yen.

The question then becomes, How to play? That’s where it gets tricky. Both DXJ and DBJP will benefit from the yen collapsing versus the dollar. But where will any real recovery in the Japanese markets come from?

DXJ’s construction creates enormous tilts in its equity exposure. Most notably, its focus on export revenues means it has just 11 percent in financials, versus nearly 20 percent in financials in the naive index approach to Japan followed by DBJP and its unhedged counterpart, the iShares MSCI Japan ETF (EWJ | B-97). DXJ also completely avoids local telecom stocks. It replaces those exposures with materials companies, health care manufacturers and consumer goods exporters.

Which approach wins in the near term here? In general, I tend to believe any bet on Japan must, eventually, involve a grass-roots recovery, which is why I’ve favored the broad approach taken by DBJP. However, one of the policy maneuvers apparently still on the table in Japan is the continuous ramping of its consumption tax. The 2014 hike to 8 percent was likely one of the main reasons economic growth has been hard to come by. It’s still slated to go to 10 percent in 2015. For that reason, at least in the short term, I think DXJ stays on top, just as it has for most of this year.

At the time of this writing, the author had no positions in the securities mentioned. You can reach Dave Nadig at [email protected], or on Twitter @dnadig.