Time May Be Right To Reconsider Japan ETFs

Japanese equities, whether offered in currency-hedged or unhedged ETFs, have been largely unpopular this year.

The two largest funds in the segment, the iShares MSCI Japan ETF (EWJ | B-93) and the WisdomTree Japan Hedged Equity Fund (DXJ | B-62), have seen net outflows of $4 billion and $5 billion year-to-date, respectively, and are among 2016’s biggest ETF redemptions.

It wasn’t that long ago that everyone wanted in on a rosy outlook for Japan under Shinzo Abe’s leadership. But economic reforms and momentum in Japan seemed to have stalled, and in recent months, many investors trimmed their exposure to Japan.

This week, following the latest election there that reinforced Abe’s leadership by giving his coalition majority in Japan’s upper house, Japanese equities have been rallying sharply—possibly offering a boost to investor confidence.

Expanded Stimulus Program Coming

Abe himself was reported saying he would “use his victory to push forward with his economic reform program,” according to CNN. In fact, he was already looking to expand stimulus spending, and in a meeting with former Fed Chairman Ben Bernanke on Monday, he said he wants to “be steadfast in accelerating our breakaway from deflation," according to Bloomberg.

In the past two days following the election, DXJ and EWJ have soared, as the chart below shows. The yen, meanwhile, has given up ground—as measured by the CurrencyShares Japanese Yen Trust (FXY | B-99)—offering DXJ an extra boost relative to its unhedged counterpart.

The recent action amounts to a complete change in trajectory to what had been thus far a difficult year for these funds, particularly DXJ. The ETF had faced steep losses in recent months as Japan’s economy disappointed and the yen strengthened. Consider the year-to-date chart below: 

Charts courtesy StockCharts.com

If you are among the investors who have trimmed exposure to Japan or altogether bailed on that market this year, should you get back in? And if so, should you opt for a currency-hedged exposure as opposed to unhedged?

The answer really boils down to your own personal investing goals. Still, we asked three ETF strategists whether it makes sense to own Japanese equities right now, and what to do about that exposure to the yen ...

• Scott Kubie, chief strategist at CLS Investments in Omaha, says the latest election should be supportive for the market, and that the market, at current levels, is attractive. But beware of the yen.

“[The election victory] provides Abe a sufficient majority to implement additional economic reforms. Additional minor reforms and maintaining existing initiatives should support the market,” he said.

“Japan benefits from improved global economic growth and its own corporate reforms,” Kubie added. “Its low valuations make the market attractive.”

Still, to him, investors looking to get back in need to consider the volatility of the yen, so consider currency hedging.

“[Japan’s] currency gets bounced around more than most because some speculative investors use it as the preferred borrowing currency for leveraged investments,” he noted. “That means the yen tends to rally in the initial stages of market declines.”

“Outside of the risk swings in the market, I expect the Japanese central bank to continue to work to devalue the yen if the economy remains slow. If you like Japan, hedging provides an extra opportunity for return,” Kubie said.

• Dave Garff, of Accuvest Global Advisors in Walnut Creek, California, remains positive on Japan, and likes current valuations there. But momentum has waned.

“We are still overweight Japan, although less so than we were six months ago,” he said. “Relative momentum there has been abysmal, but fundamentals of Japanese stocks have been stronger than expected. Valuations are still reasonable.”

If Japanese stocks are looking good, currency-hedging that exposure isn’t so much, he says.

“We are no longer hedging our yen exposure,” Garff added. “A trend follower would be in agreement with that position.”

But from a fundamental perspective, “It is hard to see why the yen should strengthen a lot more,” he said.

• Tyler Mordy, president and chief investment officer of Toronto-based Forstrong Global, says Japan is at a crossroad, but the latest election win could provide a boost to Abenomics and lead to higher asset prices.

“By some measures, ‘Abenomics’ has failed. The public debt burden has risen to about 230% of GDP—15% above its 2012 level; deflation has still been an issue, with the core measure of inflation back down at its 2013 level,” Mordy said. “Clearly, Japan is at a crossroad.”

“With Abe’s reinforced mandate and post-election pledge to double down on ‘Abenomics,’ could the Japanese equity market experience another leg upward? We think so,” he added.

Even if the country continues to face structural head winds, there are several silver linings. According to Mordy, corporations there are now “extremely lean and efficient”; “aggregate Japanese return on equity has been trending upwards”; valuations, particularly in small-caps, are extremely attractive; and locals are increasingly looking to invest as opposed to simply save.

“Japan continues to lead the world in unconventional monetary policy. The IMF estimates that the Bank of Japan will run out of government bonds to buy next year or in 2018 when its ownership will reach JPY400 trillion. The bank also owns 47% of domestic ETFs,” he said.

“Expect further forays into the realm of unorthodox policy. Notably, ‘helicopter money’—a true money-financed fiscal stimulus—will likely surface in Japan first,” he noted. “Investors may balk at the efficacy of these policies, but they should also understand that they are immensely helpful in raising asset prices.”

The ETFs

There are seven Japan total-market ETFs available today, EWJ and DXJ being the two biggest. EWJ is the veteran in the space, while DXJ is the most popular currency-hedged Japan fund.

DXJ has $6.5 billion in assets today, offering investors an exporter-focused, dividend-weighted portfolio of Japanese stocks. The fund is currency-hedged and costs 0.48% in expense ratio. With sizable liquidity, trading on average $281 million a day at 0.02% spreads, DXJ costs investors about $50 per $10,000 to own and trade.

EWJ has $13.6 billion in assets. The fund offers broader exposure to Japanese equities, covering about 85% of the investable universe of securities traded in Japan. It, too, costs 0.48% in expense ratio. Despite its larger daily average volume than DXJ, at about $408 million a day, EWJ trades with an average spread of 0.09%, putting its overall cost of ownership at about $57 per $10,000 invested, according to FactSet data.

Contact Cinthia Murphy at [email protected].