To The Moon

Over the past few months, the Japanese stock market has been on a blazing trajectory, with the Nikkei 225 Index recently breaching the 40,000-point milestone for the first time. This surge has been propelled by a host of positive factors, including hopes of interest rate cuts in the United States, easing signs of inflation, and a growing interest in artificial intelligence (AI) within the tech industry.

This milestone achievement underscores a significant uptrend driven by foreign investments amid yen depreciation and corporate governance reforms aimed at enhancing shareholder returns. Investors seeking to capitalize on this robust rebound should undoubtedly consider investing in Japanese ETFs.

While most Japanese ETFs have been soaring this year, currency-hedged funds stand out in this arena. These include WisdomTree Japan Hedged Equity Fund (DXJ), Xtrackers MSCI Japan Hedged Equity ETF (DBJP), iShares Currency Hedged MSCI Japan ETF (HEWJ), Franklin FTSE Japan Hedged ETF (FLJH), and WisdomTree Japan Hedged SmallCap Equity Fund (DXJS).

Due to the soaring US dollar depressing returns on international investments, currency-hedged ETFs outperform their unhedged counterparts. This is because a strong dollar eats into the returns of foreign investments denominated in dollars, even if international stock markets perform well, pushing them into losses. Hence, the strength of the dollar is driving investors towards currency-hedged ETFs.

Investors expecting the US dollar to appreciate relative to the yen might prefer such funds as a way to bet on the performance of Japanese stocks. When the dollar strengthens, DBJP should outperform non-currency-hedged ETFs like EWJ (see: Buffett's Bet on Japan: Five Trading Giants and the Resilience of the Nikkei 225). Investors expecting the dollar to depreciate relative to its Japanese counterpart may prefer to leave their currency exposure unhedged and instead use funds like EWJ.

Key factors contributing to the resurgence of the Japanese market include:

• Increased Foreign Fund Inflows: Foreign investors are pouring substantial funds into the Japanese stock market to capitalize on yen depreciation and bolstered corporate governance opportunities. Another reason for the surge in fund inflows is capital outflows from China amid challenges in the economy and real estate market, thereby increasing liquidity in the Japanese market and driving stock market gains.

• Weakening Yen and Economic Policies: The weakening of the yen against the US dollar, influenced by remarks from Bank of Japan Governor Haruhiko Kuroda regarding the yet-to-be-sustainably achieved 2% inflation target, benefits exporters. This currency dynamic enhances the overseas competitiveness of Japanese products, boosting earnings for export-oriented companies. Meanwhile, the Bank of Japan's monetary policies, particularly its stance on maintaining negative interest rates, underscore a cautious approach towards achieving inflation targets, impacting liquidity and investor interest in the Japanese market.

• Stable Income and Wage Increases: According to Goldman Sachs analysts, robust corporate earnings, which grew by 45% year-over-year in the final quarter of 2023, have brought significant uplift. Given the recovery in global manufacturing activity and resurgence in global commodity demand, profit prospects have improved. Additionally, major companies like Toyota, Nintendo, and Fast Retailing have raised wages in response to labor market tightness, further bolstering economic optimism.

Focus ETFs:

1. WisdomTree Japan Hedged Equity Fund (DXJ):

   With assets under management of $4.4 billion, the WisdomTree Japan Hedged Equity Fund aims to provide exposure to the Japanese stock market while hedging against fluctuations between the US dollar and the yen. It tracks the WisdomTree Japan Hedged Equity Index, targeting the Japanese stock market without currency risk. The average daily trading volume for DXJ is 939,000 shares, with an expense ratio of 48 basis points annually.

2. Xtrackers MSCI Japan Hedged Equity ETF (DBJP):

   The Xtrackers MSCI Japan Hedged Equity ETF tracks the MSCI Japan USD Hedged Index, designed to provide exposure to the Japanese stock market while mitigating exposure to fluctuations in the value of the US dollar and the yen. With assets under management of $354 million, DBJP has an average daily trading volume of 24,000 shares and charges an expense ratio of 47 basis points annually.

3. iShares Currency Hedged MSCI Japan ETF (HEWJ):

   HEWJ is the currency-hedged version of the popular fund iShares MSCI Japan ETF (EWJ). It offers broad exposure to numerous Japanese companies that may benefit from the country's stimulus policies while mitigating fluctuations between the yen and the US dollar. With assets under management close to $302.7 million, HEWJ has an average daily trading volume of approximately 140,000 shares and charges investors 50 basis points annually.

4. Franklin FTSE Japan Hedged ETF (FLJH):

   The Franklin FTSE Japan Hedged ETF provides an opportunity to enter the Japanese stock market while seeking to reduce the impact of the yen against the US dollar. It follows the FTSE Japan Hedged Index and has a low cost structure, with an expense ratio of 0.09%. FLJH has accumulated assets under management of $39.56 million, with an average daily trading volume of 26,000 shares.

5. WisdomTree Japan Hedged SmallCap Equity Fund (DXJS):

   With assets under management of $64.69 million, the WisdomTree Japan Hedged SmallCap Equity Fund offers investment opportunities in small-cap stocks in the Japanese stock market while hedging against fluctuations between the US dollar and the yen. It follows the WisdomTree Japan Hedged SmallCap Equity Index. DXJS has an average daily trading volume of 22,000 shares and charges an expense ratio of 58 basis points annually.