I've been one of the biggest cheerleaders for the WisdomTree
Japan Hedged Equity Fund (NYSEArca: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
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
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 (NYSEArca: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
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
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
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
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
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 (NYSEArca: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
For example, the First Trust Japan AlphaDex ETF (NYSEArca: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.
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
At the time this article was written, the author held a long
position in DXJ. Contact Dennis Hudachek at
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