A Cautionary Tale About DXJ
I’ve been one of the biggest cheerleaders for the WisdomTree Japan Hedged Equity Fund (DXJ) for some time now. Still, the current euphoria around “Abenomics” and the Nikkei’s massive returns on the back of a plunging yen in a short few months is starting to make me feel a bit cautious.
I’m increasingly seeing only a one-sided optimistic view on DXJ, almost as if it’s a sure bet. So, I think it’s only fitting that we cover some of the potential pitfalls of Japan, and by extension, DXJ. After all, considering that the crowd could be wrong is a critical step in your investment decision-making.
I want to be clear that I’m not calling an end to the DXJ party that has given investors more than 40 percent returns since mid-November 2012. DXJ and Japanese equities could very well rally hard for many more months.
Still, I wonder how much influence foreign institutions and hedge funds have had in the recent rally. I also think of some serious longer-term issues in Japan, including unfavorable demographics, its dependence on exports, the demoralized state of its consumer base and that the government’s mountain of debt may weigh heavily.
Investors piling into DXJ at this juncture to chase returns should think about whether they’re trading on momentum, or investing for the long haul, and remind themselves that there’s no such investment as a sure thing.
First, A Bit Of Background …
DXJ has been one of the hottest ETFs of 2013, raking in more than $3.7 billion in asset flows and returning more than 19 percent year-to-date.
Since early November 2012, when DXJ was a $530 million fund, it’s grown almost 1000 percent and is now a $5.4 billion fund. This puts DXJ within arm's reach of the $7 billion iShares MSCI Japan Index Fund (EWJ) $7 billion.
Of course, DXJ’s ballooning assets are not only due to its massive inflows, but also to its surging net asset value.
The reasons for DXJ’s sudden superstar status are probably well known by now, so I won’t dig into it in detail. In a nutshell, DXJ’s massive outperformance is predominantly attributed to its currency-hedged feature.
Kudos to the folks at WisdomTree for being early birds in spotting the negative correlation between the yen and Japanese equities. They tweaked their existing Japan ETF strategy in 2010 to hedge out the yen exposure.
Now The Potential Pitfalls
It shouldn’t come as a surprise to see a sharp relief rally in Japanese equities now that the formerly ultra-strong yen—which was choking off the profits of some of Japan’s largest multinational companies—is falling hard from all-time highs.
Still, the yen’s depreciation has come a long way in a few short months in the aftermath of Shinzo Abe’s election. Since mid-November, the yen has plummeted almost 20 percent. I think most investors, including Japanese officials, probably weren’t expecting such a large plunge in such a short time frame.
Interestingly, Abenomics has thus far given the markets a steroid shot from just strong rhetoric about ending deflation through unlimited asset purchases by strong-arming the Bank of Japan.
The Bank of Japan hasn’t actually started its massive large-scale asset purchases, currently scheduled to begin in January 2014. That said, it certainly looks like Abe will get an ultra-dovish governor in Kuroda, the newly appointed Bank of Japan governor.
Yet should the yen plunge below 100 yen/dollar (which is only 5 percent from where it’s currently trading), I wonder if we might start to hear a more toned-down rhetoric from Japanese officials to try and limit a further plunge in the yen.
Several Japanese officials have previously hinted already that they don’t want the yen to weaken beyond 100-110 yen/dollar.
In such a scenario, I wonder if the Nikkei would continue its explosive performance.
Two other big questions also remain.
First, just because the Bank of Japan embarks on a massive quantitative easing program unlike anything we’ve seen in the past, will that actually create the targeted 2 percent inflation rate policymakers are aiming for?
And secondly, if they’re able to create inflation, will Japanese citizens start spending and investing?
Betting on a turnaround in Japanese consumption has been about as ill-fated a trade as betting against the U.S. consumer. We’ve seen a very strong trend in place for the better part of two decades:Japanese love to save.
It’s going to take a lot to turn that trend around.
Since the bursting of the equity and real estate bubble in 1990, Japan has been devastated by recession after recession and battling deflation for the past few decades. An entire generation of Japanese workers, now in their mid-20s, has never seen boom times, and has thus been taught their whole lives to save for a rainy day.
I also wonder just how much of the recent surge is due to foreign institutions and hedge funds pouring money into the current hottest trade. Hedge funds can pile into the hottest trades, only to exit them in haste, sometimes at a faster rate than they entered, when the tide turns.
On the demographic front, Japan has some serious well-known issues with a growing aging population with not enough younger workers to support them. I don’t see Japan really tackling that issue, even though there are probably millions from developing Asian countries who would love to immigrate to Japan.
To add to the doubt, Japan is also one of the most indebted countries in the world. National debt is estimated to be close to $13 trillion. While that total is less than U.S. indebtedness, Japan’s debt-to-GDP is over 220 percent, the highest of any country in the world.
Now they’re talking about taking on even more debt and creating inflation by printing unlimited amounts of yen to jump-start the economy. If interest rates were to rise in Japan, that might make servicing debt that much more burdensome.
Finally, Japan is still heavily dependent on exports to the United States and China. If there’s another global slowdown or meltdown in the coming years, it would be hard to imagine Japan walking away from that unscathed.
Back To ETFs …
I think there’s really been two ways to play the resurgent Japan on the equity front. Currency hedged, or un-hedged. That means currency-hedged funds such as DXJ or the db x-trackers MSCI Japan Hedged Fund (DBJP), and non-hedged funds such as EWJ.
That said, should the yen plateau or level off, being selective in which type of fund you choose based on holdings or sector tilts might start to matter again.
If you think Abenomics will eventually turn the tide and spur consumption and investment in Japan, then an ETF tilted toward domestic demand—which DXJ shies away from—might look more promising.
For example, the First Trust Japan AlphaDex ETF (FJP) separates itself from its peers, due to its rigorous quant-driven methodology and tiered, equal-weight strategy.
Most importantly, over 30 percent of FJP is weighted in consumer cyclicals, with another 27 percent going to industrials. FJP is also heavily tilted toward small- and mid-caps (over 70 percent), while sporting a lower price-to-earnings ratio.
Final Thoughts
At the end of the day, I currently still prefer DXJ over its peers as the way to play Japan. That said, I also think the investment case for DXJ just isn’t as compelling today as it was when the yen was at 75 yen/dollar.
While currency-hedged products tend to lower volatility for most international ETFs, with Japan, it may be the opposite. If the yen rebounds sharply, funds like DXJ are likely to see more downside risk than non-hedged funds like EWJ.
Clearly, none of us knows where Abenomics will take us or how the next phase of the Japanese recovery will unfold. It’s certainly the most aggressive attempt we’ve seen from Japan to quash deflation, which has been plaguing the nation for years.
While a bold move was badly needed to jump-start the anemic Japanese economy, I can’t help but feel there’s a hint of desperation here. This seems almost like an all-in, “desperate times call for desperate measures” attempt.
Here’s to hoping that Abenomics will reinvigorate Japan on the domestic level and that this could be the game changer we all hope for, without ushering in a slew of unintended consequences down the line.
At the time this article was written, the author held a long position in DXJ. Contact Dennis Hudachek at dhudachek@indexuniverse.com .
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