The WisdomTree Japan Hedged Equity Fund (DXJ) is pulling in assets more quickly than any ETF in a while, and it’s all linked to Japan’s aim to weaken its currency. But is this just hot money that will run for the exits the moment the yen looks to be strengthening again? Jeremy Schwartz, WisdomTree’s director of research, told IndexUniverse.com Correspondent Cinthia Murphy he didn’t think so.
Schwartz sees DXJ as a lasting tool to help investors control currency-related volatility in their portfolios. Still, he isn’t convinced that the success of DXJ is some harbinger about the prospective nature of currency-hedged strategies in general, particularly in the emerging markets, where he reckons currencies are likely to keep appreciating against the dollar and pump up returns for U.S. investors for quite some time.
IU.com:DXJ has been on a roll, raking in more than $800 million in fresh assets in 2013 alone on a weakening yen. Is DXJ’s rise in popularity a result of Japan’s unique situation or an example of investors’ growing demand for currency-hedged funds?
Schwartz :When we first started looking at currency-hedged ETFs, we first looked at a very broad international fund—we like to call it our EAFE competitor. It was a very important strategic fund, because by hedging the currency exposure in the portfolio, you lowered the volatility by 2 to 3 percentage points a year. You were essentially getting S'P 500-like volatility out of an international equities portfolio. That’s a good way to access international markets.
The case for Japan, however, has been in some ways a very unique one, because it’s the only country in the world that has such a strong negative correlation between the strength of the currency and the equity market. And you have this 30-year trend where you saw deflation and the strengthening of the yen really hurting companies’ revenues. Now that the yen has been weakening, markets there have been really rallying.
But the key here is that while it makes sense to increase your exposure to Japanese equities in this current environment, because the yen is weakening—as it has in the past few weeks—unless you have a currency hedge, it will really hurt your U.S.-dollar returns. That’s where DXJ comes in.
IU.com:From that perspective, does DXJ have a life after the yen is done weakening? How sticky are these assets once the yen slide fades?
Schwartz :That’s an interesting question. DXJ has become a very tactical trading tool that people are using to gain exposure to Japan because the yen is weakening. It’s hard to say where the yen will go. Just five years ago, we were looking at 120 yen to the dollar, and now it’s only at 90 to the dollar, so you could argue that there’s still a long way to go here, but that’s hard to say.
But the question remains:Why is it the default to take on currency risk when investing in international equities, like in EWJ? We are trying to target the pure equity market without currency risk, so you could say that DXJ does have a strategic place after the yen weakens as a way of taking away currency risk from an international equities portfolio.
IU.com:What’s unique about DXJ’s success so far, especially when we compare it with the db-X MSCI Japan Currency-Hedged Equity ETF (DBJP)? Both are currency-hedged Japan equities portfolios, but your fund is stealing the show in terms of asset gathering.
Schwartz :I think it goes back to when we launched the Japan Dividend Index, which was un-hedged, in 2006, and we saw that it wasn’t differentiated enough from its competitors until we added a currency hedge element to it in April 2010. In our early days with this strategy, we actually were very much like the broader Japan equities exposure, but that changed in 2010. The primary lesson here is that when you are first to market with a novel idea, you often become the de facto way of accessing that segment, and we were first to market with a currency-hedged way of owning Japan. We have also established good trading and solid assets, which helps.
When you also look at the different methodologies, we do track different stocks—DBJP tracks an MSCI index—and we have added a filter to select stocks of companies that have a global revenue base, so we exclude companies that are purely local to Japan. That means if you’re looking for companies that are benefiting from a weakening yen, we believe our fund is in a better position.
But I really think a lot of it comes down to that first-to-market advantage, as well as size and trading liquidity.
IU.com:As far as Japan, what’s your view on what the next 12 months hold for that country? Will the BoJ be able to pull this off?
Schwartz :What’s amazing is that they haven’t done much other than say what they are going to do and the yen has already moved so much! They are trying to end deflation and target inflation at 2 percent, and they will use aggressive easing to accomplish that, and they are also going to buy bonds.
The market is clearly sentiment-driven now, and just by trying to change the expectations, Japan has already accomplished some of its goals. Many were looking for a 90-yen to the dollar level, and we are not far from that already—before actual measures are implemented. It’s hard to say what will come next because the details are still a little fuzzy on what some of their official targets are, so we’ll have to wait and see. But we know they are focused on it and committed to it.
Japanese stocks have been in a very long bear market, so they are still relatively cheap, and there are some low valuations versus the rest of the world, depending on the metrics you use—like price to book ratio, and dividend yields. So on a valuation basis, there are good prospects to owning Japanese equities, and this currency weakening is really the additional capital to be made in this space.
IU.com:Currency-related ETFs still seem relatively new to a lot of investors, especially because the dollar has been in their favor for so long, but do you think this year, as we hear projections for a stronger dollar, could be the year when currency-focused funds make it big?
Schwartz :I think you have to be more and more selective about what currencies you want to have exposure to. In the sense that the dollar has been declining for much of the last decade, a lot of your returns in funds like those that tap into the EAFE market and other developed economies have come from currency gains. And that may not be the case in the future. Look at the euro and the yen recently—those are good examples of a quickly changing environment.
IU.com:Are the dynamics different when we look at currency exposure in emerging markets?
Schwartz :We are much more bullish long term on emerging market currencies, because they have very strong fundamentals, such as good debt-to-GDP ratios, stronger growth rates and higher interest rates. We are already seeing more flows into local emerging market debt funds versus dollar-denominated debt. That’s the type of thing we’re going to be seeing more of as investors focus on EM currencies.
It’s interesting, because some people—not us—have been launching strategies like a Brazil currency hedged fund, and others like it, but it can be very costly to hedge when you buy EM currencies, so I don’t think those make sense. There aren’t a lot of expectations that in the developed world the euro, the yen, the pound should appreciate against the dollar, and the cost of hedging those currencies is minimal. But when you look at emerging markets, you have higher interest rates there, which makes it costly to hedge that currency, and quite frankly, I think you’d want that currency exposure over time.
All that’s to say that currency as an asset class itself is a different theme than deciding whether you want currency exposure in a portfolio of bonds and equities, and the latter is certainly where investors need to be using more discretion.
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