Hottest Trade Of 2014 Losing Steam

Currency-hedged Japan equity ETFs were some of the most popular funds in 2014, delivering solid outperformance relative to unhedged strategies as Japan’s Prime Minister Shinzo Abe pushed through his reform agenda. But that trade has lost steam in 2015.

Consider that in the 12 months ended Dec. 31, 2014, the largest currency-hedged Japan ETF, the WisdomTree Japan Hedged Equity ETF (DXJ | B-67), outperformed the iShares MSCI Japan ETF (EWJ | B-99) by roughly 14 percentage points. Similarly, the Deutsche X-trackers MSCI Japan Hedged Equity ETF (DBJP | B-78) was ahead 11 percentage points relative to EWJ.

These ETFs cover similar equity universes, but DXJ and DBJP hedge out the impact that currency fluctuations have on portfolio returns.

That performance chart looks very different year-to-date, with DXJ and DBJP clear underperformers so far in 2015.

Charts courtesy of StockCharts.com

Why Currency Hedge

Currency hedging became all the rage due to the strengthening of the U.S. dollar. In broad terms, a strong dollar can be detrimental to international equity portfolio returns for U.S. investors. And as the U.S. emerged—as Richard Bernstein recently put it—the “secular winner” leading the global economy out of the financial crisis, investors were faced with dollar strength they hadn’t seen in some 15 years.

That dollar rise came as several countries raced to devalue their currencies in an effort to spur growth and competitiveness amid the global economic slowdown. Japan, specifically, went through great lengths to weaken the yen.

All of that boded really well for funds such as DXJ, which were able to capture gains associated with Abe’s growth initiatives, but protect investors from a rising dollar.

But in recent months, the dollar lost ground against major currencies, including the yen. DXJ’s competitive advantage over EWJ all but evaporated as far as the currency element is concerned.

What Happens Next?

From a technical standpoint, it could be that the dollar will find enough footing to change course and regain upside momentum. Or maybe not, David Rodriguez, quantitative strategist for DailyFX.com, said.

“The U.S. dollar looks at risk of further declines—particularly if it trades below ¥119 versus the Japanese yen,” Rodriguez said in a recent commentary.

“A break below said level would help confirm that the USD has made a sustained turn lower and would have fairly important implications for other USD-based currency pairs,” he added. “Yet trading above keeps markets in suspense as the greenback would likely stick to its large and choppy trading ranges across the board.”

If the dollar path is unclear at this point, so is what happens next in Japan.

Japan’s Unified Front

Japan’s domestic and foreign demand fell below expectations in recent months, and Abe has now to restore his credibility as he tries to revamp “pro-growth economic policymaking,” said Jesper Koll, CEO of WisdomTree Japan.

“With the controversial new security bill now largely in the rearview mirror, ‘Team Abe’ will want to re-establish economic policymaking credentials as quickly as possible,” Koll said in a recent commentary.

“The first focus of counter-policy is likely to be added fiscal stimulus,” he added.

But restoring that credibility hinges on whether Abe, the ministry of finance and the Bank of Japan’s ability to show they are on the same page, pursuing the same goal—all focused on an “all-out pro-growth policy,” Koll said.

“This is the real challenge for Team Abe in the coming four to six weeks: one team, one dream,” he added.

Investor Demand Strong

If performance has lagged, and the outlook seems uncertain, ETF investors seem thus far relatively un-phased by the turn of events. Demand for exposure to Japanese equities remains strong.

So far in 2015, DXJ has attracted more than $4.6 billion in fresh net assets, according to ETF.com data. EWJ has gathered $4.4 billion in the same period, while DBJP has seen net inflows of $750 million.

Contact Cinthia Murphy at [email protected].