Dillian: Not All Currency-Hedged ETFs Work

December 10, 2013

Success of Japan-focused DXJ doesn’t mean it will translate to other countries.

Jared Dillian is the editor and publisher of The Daily Dirtnap, a market newsletter for investment professionals, and the author of “Street Freak: Money and Madness at Lehman Brothers.”

WisdomTree’s Japan Hedged Equity fund (DXJ | B-45), the currency-hedged Japanese equity ETF, is one of the greatest ETF success stories of all time. Talk about being in the right place at the right time. Gathering almost $10 billion in assets under management in a year is what startup ETF providers dream of, but can DXJ’s success be replicated?

First, we have to examine the motivations for currency hedging. When an investor buys a stock in a foreign country, the stock is denominated in foreign currency. This means the investor has to exchange local currency for foreign currency, which he will then use to buy the shares.

The problem is (if you consider it a problem) that now the investor has foreign-exchange risk to go along with his equity risk. In addition to worrying about whether the stock is going to appreciate, even if it does, it may be completely offset by losses in the foreign currency.

You might think this would concern people, but my experience with international investors is that they aren’t terribly concerned about foreign-exchange risk, or if they are, they factor it into a top-down macroeconomic analysis that dictates which countries they will invest in in the first place.

For the many years that the dollar was weak, European investors—especially the pension funds—just stayed away from U.S. stocks altogether. Since the dollar has strengthened, they have started to come back. and I suspect they are a presence in U.S. capital markets once again.

So, pre-Japan reflation, there would never have been much demand for a currency-hedged country ETF, because professional investors gladly accepted currency risk as part of the investment. To hedge it out would have been considered a little too cute—to go one way on the stock and the other way on the currency.

Japan was and is a special case. In Japan, you had a 20-year bear market, with losses of 75-80 percent over 20 years, a situation wherein most rational people considered it unlikely that the market would go much lower. But government debt had ballooned to more than 200 percent of GDP.

Anyone with an intimate knowledge of Japan’s public finances knew that it would be highly likely that a situation would develop wherein bond yields became unhinged and Japan had to print massive amounts of yen to buy Japanese government bonds to keep yields stable and borrowing costs low.

It hasn’t played out quite like this—not that quickly—but these things take time. When Bank of Japan Governor Haruhiko Kuroda really revved up the asset purchases earlier this year, the bond market experienced unprecedented volatility. Japan-watchers like me wondered if we were witnessing a collapse in progress (we weren’t).

But in Japan, the yen and the stock market have historically been inversely correlated because of Japan’s status as an exporter to the West, and this inverse correlation has persisted even though the huge trade surplus has turned to deficit.

By purchasing power parity or any other measure, the yen was wildly overvalued, and the prospect of virtually unlimited printing pushed it about 25 percent lower in just a few short months, one of the most violent moves of any G10 currency in recent memory. Weaker yen, more exports, higher stocks, goes the logic, and the Nikkei was up 70 percent at one point this year.

So—back to DXJ. The smart folks at WisdomTree saw this coming, and dreamed up DXJ long before anyone would have thought such a vehicle was necessary.



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