Thanks to Japanese Prime Minister Shinzo Abe's policies aimed at reviving growth in the economy, popularly known as "Abenomics," Japanese equity prices soared to record levels las year.
However, 2014 has been anything but remarkable for the Japanese equity markets. The major Japanese stock indexes have faced huge sell-offs and extreme volatility in light of low economic growth and deflationary concerns, coupled with global macroeconomic developments such as the tapering of quantitative easing by the U.S. Federal Reserve.
Will the third arrow score a bull's-eye?
That said, the party is by no means over for the land of the rising sun. Recently, as reported by CNBC, Prime Minister Abe announced a slew of policy measures aimed at reviving growth in the economy, popularly know as the "third arrow" of the PM's policies.
Measures that should encourage investors include the reduction of the corporate tax rate to less than 30% and deregulation of the country's highly restricted agricultural industry. Such market-friendly policies should not only enhance the profit margins and return on equity of Japanese companies, but could also give a significant boost to the stock markets, making a bullish case for Japanese stocks going forward.
The best choice to capitalize on this trend
For an investor seeking exposure to Japanese stocks, my recommendation would be the WisdomTree Japan Hedged Equity ETF (NYSEMKT:DXJ). The ETF tracks the WisdomTree Japan Hedged Equity Index, an index designed to measure the performance of 328 Japanese stocks listed in the Japanese markets. This fund employs a unique strategy.
When you're invested in a foreign market, you are primarily exposed to two types of risks: 1) risk that your investments will lose value and 2) risk that your domestic currency will strengthen in relation to the currency of the foreign economy. You may lose money in both cases.
However, the Japan Hedged Equity ETF hedges the currency risk associated with investing in Japanese stocks denominated in the Japanese yen by utilizing currency forward contracts -- derivative instruments that are used to manage currency risk. With these contracts, the ETF locks in a particular rate for the U.S. dollar versus the yen. So even if the yen were to lose value against the dollar, investors' returns would be safe, as the forward contracts have already defined an exchange rate for the two currencies. This means you're essentially left with the pure equity returns without the adulteration of currency fluctuations.
The strategy works best when the yen actually looses value versus the greenbacks. If the opposite happens -- i.e., the yen strengthens against the U.S. dollar -- investors will be deprived of the additional currency returns. However, given the present scenario, the latter seems less probable, primarily because the "third arrow" of Abenomics, coupled with monetary tightening measures in the U.S., will likely lead the yen to weaken against the greenback, which is why I believe this strategy employed by the ETF will prove fruitful for U.S. investors.
Currency impacts matter
The chart below shows the comparative performance of the WisdomTree Japan Hedged Equity ETF and two other ETFs tracking Japanese stocks: the iShares MSCI Japan ETF (NYSEMKT:EWJ) and the First Trust Japan AlphaDEX ETF (NASDAQ:FJP). These two ETFs track almost the same stocks as the currency-hedged ETF, but they do not employ the currency-hedge methodology.
In order to showcase the impact of currency on overall returns, I'll show the period from December 2012 to May 2013, when the first round of monetary easing was introduced.
Not surprisingly, the currency-hedged ETF crushed its non-hedged counterparts, as the yen's devaluation was factored into the total returns of the non-hedged ETFs but hedged out of the currency-hedged ETF.
The WisdomTree ETF charges an expense ratio of 0.48% and has managed to amass a huge asset base of $10.7 billion. Its top holdings by weight include Toyota Motor Corp (5.2%), Mitsubishi Finance Corp (5%), Japan Tobacco Inc (4.1%), and Canon Inc (3.4%).
In light of the above facts and research, it is probable that the Japanese equity markets are in for the same kind of investor reaction they experienced when Abenomics 1.0 was implemented. However, investors should also realize that it will take time to implement these policies and realize their full potential.
In any case, given the possibility of positive economic developments, the bullish case for Japanese equities, and the impending devaluation of the Japanese yen, happy times surely seem to be in store for the currency-hedged ETF.