Buy Japan and Sell Yen, All at Once

04/25/2011 2:13 pm EST

Focus: ETFS

Paul Justice

Associate Director of North American ETF Research, Morningstar, Inc.

Buying Japanese multinationals while hedging out the yen exposure is a snap, thanks to this promising ETF, write Paul Justice and Patricia Oey of Morningstar ETFInvestor.

After hovering near all-time highs against the US dollar in the year to date, the Japanese yen may weaken in the near future. An attractive way to play this trend would be through WisdomTree Japan Hedged Equity (DXJ), an exchange traded fund that hedges out the currency fluctuation between the yen and the US dollar.

As a result of the terrible disaster in March, we could see a more focused federal government address Japan’s economic problems and take a more proactive approach to managing the yen’s exchange rate, which would be a positive for Japanese companies.

A weaker yen may also have the support of the G7 group of top developed economies in the near term. In the days following the earthquake, the G7 worked together to bring the yen back above ¥80 against the US dollar after it hit an all-time high of ¥76 to the dollar.

In the medium term, concerns about Japan’s debt burden—which will be made heavier by rebuilding efforts—could weigh on the yen. A weaker yen, combined with a recovering US economy and growth in emerging markets, would benefit Japan’s large-cap exporters. [One of DXJ’s top constituents, Canon (CAJ), was recently recommended by Elliott Gue and Yiannis Mostrous—Editor.]

Japan Hedged Equity invests in large-cap, dividend-paying Japan equities and has a slight value tilt. By hedging its yen exposure, the ETF is expected to outperform an un-hedged, broad-market Japan equity fund when the yen weakens relative to the dollar.

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There are a number of well-known issues that continue to weigh on Japanese companies.

Despite years of supportive fiscal and monetary policies, Japan’s economy continues to be sluggish. And after all that stimulus spending, Japan’s public debt as a percentage of GDP is greater than 200%, the highest in the developed world.

This situation will likely be exacerbated by Japan’s rapidly aging population (more than 20% of its population is over 65) and rebuilding efforts following the March earthquake, tsunami, and nuclear disaster. [For more on Japan’s fiscal and demographic problems, see a recent excerpt from Gary Shilling—Editor.]

But one of the biggest issues for many of Japan’s large-cap exporters has been the rising yen. From January 2008 to December 2010, the yen rose almost 40% against the US dollar.

Japan Hedged Equity tracks a namesake index that measures the performance of dividend-paying companies incorporated in Japan and listed on the Tokyo Stock Exchange. Components are weighted based on annual cash dividends paid, which tilts the index toward larger companies.

The fund’s largest sector allocations are financials, industrials, and consumer discretionary (which includes auto makers and consumer electronics companies), accounting for 17%, 16%, and 14% of the portfolio, respectively. The latter two sectors are export-oriented, with the industrials sector more exposed to emerging markets.

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