ETF Spotlight: April 2011

Published on by on April 1, 2011

Each month, we highlight an ETF flying under the radar of most investors that offers exposure to a unique asset class or investment strategies. This month, we take a closer look at a Japan-Equities fund from Wisdom Tree that offers a compelling way for investors to achieve equity exposure while also protecting against currency fluctuations: the Wisdom Tree Japan Hedged Equity Fund (DXJ).

March was a wild month to say the least. Investor uncertainty peaked as a slew of developments threw the markets off balance, including ongoing tensions in the Middle East, with protests erupting in Syria, while Japan was unfortunately struck by a truly devastating earthquake. The catastrophe which began on March 11th remains to be the headline story, as thousands of innocent lives were lost and Japan is still struggling extend relief efforts and maintain control of its nuclear reactors, which endured alarming damage following the quake-tsunami. The death toll has reached over 11,000 innocent lives, while Japanese authorities estimate damages to reach $300 billion, and radiation concerns are still of a high-priority. As a result, in a truly historic fashion, the G-7 intervened in the currency market following the disaster and their intention remains to drive down the Japanese Yen, and help the export-heavy nation rebuild with cheap money. The G-7 intervention has thrown the currency markets into a frenzy and Japan’s future is still uncertain, although recovery certainly is on the horizon.

Many investors, including billionaire Warren Buffett, are using this extraordinary event as a buying opportunity. During his most recent visit to the region, Buffet said, “Frequently, something out of the blue like this, an extraordinary event, really creates a buying opportunity. I have seen that happen in the United States, I have seen that happen around the world. I don’t think Japan will be an exception”. Buffet also went on to add that it will take some time to rebuild, however, the development of Japan’s economic future is largely unchanged. Investors who are interested in gaining Japanese equity exposure, but worrisome of the yen’s volatility, can look to Wisdom Tree’s Hedged Japan Fund.

DXJ tracks the WisdomTree Japan Hedged Equity Index, which is designed to provide exposure to¬† securities in Japan, while at the same time hedging exposure to fluctuations between the value of the U.S. dollar and and the Japanese yen. In essence, the fund seeks to track the performance of equity securities in Japan that is attributable solely to stock prices without the effect of currency fluctuations. The buying opportunity for Japanese stocks right now is tremendous not only because of the recent sell-off, but especially when considering the G-7′s intentions to continue driving the Yen lower as Japan rebuilds and recovers.

Understanding the historical performance of the Japanese equity market, as it relates to the yen’s performance, is the key link which illustrates the attractiveness of the opportunity currently at hand. Since World War II, Japan’s robust manufacturing and ongoing technological advances have allowed the island to have a far-reaching impact on the rest of the world through its export-focused economy. Interestingly enough, Japan is rare case in the developed world because of the highly-negative correlation between the countries equity market’s and the strength of its currency. Simply put, performance and profitability of Japanese exporters is hindered by a strong yen, since foreign buyers are forced to spend more to purchase the same goods.

Since the financial crisis of 2007, the Japanese Nikkei stock market has lost around 40%, while during the same period the Japanese yen has appreciated roughly 47% versus the U.S. dollar. In 2010 alone, the yen appreciated by almost as much as 15% versus the dollar. When considering a three-year correlation of equity and currency markets, Japan exhibits a negative .56, while Canada, Australia, and all of Europe all exhibit positive correlation of nearly .50.

Many of the funds top holdings derive a significant portion of their revenue from overseas exports, especially the U.S., and therefore gains in the yen relative to the dollar have a negative impact on operating profits for Japanese exporters. For instance, Japan’s electronics companies lose a combined $383 million in annual operating profit for each point that the yen appreciates against the dollar. More specifically, Toyota, which is within the funds top five holdings, looses an estimated $360 million from operating profits for every point that the yen gains against the greenback.

Japan still faces many challenges going forward, including mounting debt and deficit problems as well as an aging demographic. However, if the negative correlation between yen strength and equity performance continues to play out, then the country’s largest exporters are poised to benefit. DXJ is an appealing investment because it allows for U.S. investors to reap the rewards of a future rally in Japanese equities, while also protecting against fluctuations in the dollar/yen exchange rate. The fund has just over 300 holdings, diversified primarily across industrials, consumer goods, financial services, and communications. DXJ has attracted close to $500 million in assets under management, and it has an expense ratio of 0.48%, which is the lowest within the Japan-Equities category.

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