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ETF Specialist

Watch for Currency Effects on Japan ETFs

A falling yen benefits Japan's exporters but hurts unhedged Japan equity ETFs.

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While the Nikkei 225 has returned almost 20% year-to-date, the largest Japan equity ETF, iShares MSCI Japan Index (EWJ), has returned less than 10%. EWJ, like most foreign equity ETFs, does not hedge its foreign currency exposure. As such, this ETF's returns reflect both the performance of its underlying index, as well as changes in yen/dollar exchange rate. Over the last few years, investors in EWJ have benefited from the steadily appreciating yen against the U.S. dollar. But after the Bank of Japan boosted its asset purchase program and set an inflation target of 1% last month, the yen began to fall. This falling yen is now providing a tailwind for Japan's large-caps, many of which are major exporters, and has helped drive a rally in Japanese stocks.

In such an environment, it makes sense to invest in an ETF that hedges its foreign currency exposure, such as WisdomTree Japan Hedged Equity (DXJ). DXJ tracks a dividend-weighted index, so while it won't provide the performance of the Nikkei, it should outperform an unhedged fund such as EWJ when the yen is falling against the dollar. In addition, this ETF has a slight value tilt. Historical data have shown that the value premium, the tendency for value stocks to provide greater risk-adjusted returns relative to growth stocks over the long term, also exists in Japan. However, investors should note that value strategies can underperform for periods of time.

Patricia Oey does not own (actual or beneficial) shares in any of the securities mentioned above. Find out about Morningstar’s editorial policies.

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