Lately, the land of the rising sun has been the land of the falling yen. While single-country equity exposure to Japan= has provided investors with relative outperformance year-to-date (YTD), they appear to be better off shedding the currency drag. That strategy is more enticing given the yen has been mired in a 40-year low recently.It’s a phenomenon known as the international investor’s paradox, which is the desire to capture overseas equity growth and portfolio diversification. However, it comes paired with the volatility tied to foreign exchange= (FX) fluctuations. In essence, unhedged international investing forces individuals to make two distinct bets—one on the underlying corporate fundamentals, and another on the direction of a foreign currency relative to the U.S. dollar (USD). There’s an easier solution to this: currency-hedged ETFs.=Key Takeaways:
Unhedged international investing forces individuals to make two distinct bets—one on localized corporate fundamentals and another on the direction of foreign currencies relative to the U.S. dollar.
Japan’s export-driven economic renaissance benefits from a weaker yen, but this currency drag dilutes returns for unhedged investors unless they utilize currency-hedged strategies.
Because major domestic U.S. indexes are already heavily exposed to a weakening dollar through multi-national revenue streams, adding unhedged international equities simply doubles down on that existing currency risk.
See More: Japan’s Record Run: The Land of the Rising ReturnsJapan's Economic RenaissanceJapan’s economic renaissance is fundamentally an export-driven story. Based on the International Monetary Fund (IMF), Japan is the fourth-largest economy in the world though its corporate engine doesn’t derive its fuel from spending by the domestic consumer. Instead, it relies on international buyers purchasing Japanese goods, which creates an economic inverse relationship: a lower yen directly fuels accelerating corporate earnings and export volumes.
At the same time, major corporate governance shifts are compounding Japan’s appeal. The Tokyo Stock Exchange (TSE) recently initiated its most aggressive overhaul in 60 years, demanding that companies with low price-to-book (P/B) ratios disclose explicit initiatives for improving valuations. In response, corporations sought to increase shareholder value by hiking dividends and buybacks.Japan is also in good graces with Warren Buffett, whose Berkshire Hathaway firm recently increased its stakes to nearly 10% across five major Japanese trading firms. With discounted forward price-to-earnings multiples, the country’s equities make for a compelling value-oriented choice.Bypassing The Currency DragOf course, adding a speedbump to Japan’s economic comeback story is a depressed yen. While the U.S. Federal Reserve has kept its benchmark rates elevated between 3.5% to 3.75% amid sticky inflation, the Bank of Japan (BOJ) hasn’t kept pace, only raising its rate to 1%.
In addition to the widening gap versus the U.S. dollar, applying more downward pressure to the yen is the carry trade that involves investors borrowing yen to purchase higher-yielding assets. Moreover, rising oil prices are forcing Japan to aggressively sell its yen for dollars to cover the costs associated with heavy energy imports. The bifurcation in performance between Japanese equities and its yen against the dollar is apparent when looking at the MSCI Japan and PHLX Yen indexes. As mentioned, while a reeling currency can bolster the earnings of Japanese corporations by allowing their exports to outprice competition, it simultaneously dilutes returns of unhedged investors left exposed to a falling yen. To solve this friction, currency-hedged strategies are built into ETFs such as the WisdomTree Japan Hedged Equity Fund (DXJ B-). The fund was among those highlighted at TMX VettaFi’s Midyear Market Outlook Symposium where Jeremy Schwartz, Global Chief Investment Officer at WisdomTree, discussed the structural benefits of currency hedging. The firm is a pioneer in bringing currency hedging strategies to retail investors via an ETF wrapper.
To bypass the yen’s currency drag, DXJ provides exposure to Japanese dividend-paying companies with an explicit exporter tilt by tracking the WisdomTree Japan Hedged Equity Index. To prevent value traps, it screens for companies exhibiting a combination of quality and momentum. The fund’s strategy also applies a static currency hedge using one-month forward FX contracts to neutralize fluctuations in the yen.DXJ, EWJ, and HEWJSince DXJ’s inception in 2006, it’s outpacing the unhedged iShares MSCI Japan ETF (EWJ A) by over 160 percentage points. By layering a currency hedge on top of a highly selective portfolio, DXJ is able to capture this double-alpha effect during a weaker yen regime.A closer, apples to apples comparison might be to pit EWJ up against the iShares Currency Hedged MSCI Japan ETF (HEWJ B-). In that regard, the hedged iteration has also been outperforming the unhedged variant since 2014.See More: Currency: The Hidden Alpha in International ETFsWhy Hedging Works GloballySchwartz also noted that the strategic benefits of currency hedging extend far beyond Tokyo, presenting a compelling case for single-country and regional allocations across the globe. While Japan presents a timely case study due to the extreme divergence of the yen, the same currency hedging strategies can apply to other single-country and regional exposures like the Eurozone. With that, there’s also ETFs like the WisdomTree Europe Hedged Equity Fund (HEDJ B) or the Xtrackers MSCI Europe Hedged Equity ETF (DBEU A) to consider.
Like all strategies, currency hedging has its detractors. WisdomTree’s research explicitly debunks certain long-standing myths that prevent investors from hedging their broader international allocations. A couple of common myths include:
“Currency exposure is a wash in the long run”: While the case can be made that currency returns have hovered near negligible levels over multi-decade periods, the exposure becomes more crucial when trimming those timeframes. Over the short and medium term periods, currency exposure introduces extreme, uncompensated risk. WisdomTree data tracking international equities demonstrates that across 10- and 15-year periods. Unhedged currency exposure increased portfolio volatility by 25.1% to 25.9% compared to an equity-only (local return) portfolio.“Currency hedging is too expensive to implement”: In reality, investors are frequently paid to hedge according to prevailing interest rate differentials. In the current higher-for-longer rate environment, the interest rate gap between the U.S. and lower-rate foreign markets creates a positive cost of carry. By utilizing highly liquid forward contracts on currencies like the yen (JPY), euro (EUR), or British pound (GBP), USD-based investors effectively borrow a low-interest foreign currency and invest the proceeds in a higher-yielding USD environment, thereby allowing them to collect the differential. As WisdomTree’s research noted, this annualized carry rate remains roughly 1% above its historical average.Redefining Portfolio DiversificationAnother common objection to hedging is that a weakening U.S. dollar can act as a natural portfolio diversifier. However, Schwartz notes that American investors are completely miscalculating their existing currency risks, leaving themselves overexposed to a single directional bet against the greenback.
“Let me establish one baseline which I think people don’t have: they bet too much against the dollar forever,” Schwartz said. “This is something you’ve heard me say for the last 15 years since we were the first firm to do currency hedging. You don’t have to bet against the dollar going to buy international. The dollar is a headwind to corporate profits when the dollar’s really strong. We have a lot of multinationals with our earnings abroad, so you already have a lot of weak dollar bets in your S&P 500 actually.”
To Schwartz’s point, major U.S. indexes are heavily weighted toward multinational mega-caps. For example, Apple derives a majority of its revenue from hardware sales overseas while Meta soaks up ad revenue from international users. That said, a typical domestic portfolio is already highly sensitive to a weakening dollar. Adding unhedged international equities simply doubles down on this exposure.
By incorporating currency-hedged strategies for single-country allocations like Japan, investors can isolate global growth to localized corporate fundamentals, earnings acceleration, and structural market reforms. In doing so, investors who timely separate equity returns from foreign exchange volatility ensure that their international allocations serve as an alpha-generating portfolio diversifier sans the currency drag.
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