WisdomTree Europe
JAPAN EQUITY UCITS ETF – USD HEDGED
DXJ
Don’t Let the Yen Detract
from Japan’s Equity Rally
On 16 December 2012 Prime Minister Shinzo Abe was elected as Japan’s Prime Minister. The term “Abenomics” was born,
signifying an attempt to reinvigorate the competitiveness of the world’s third largest economy. The policies were organised
into three “arrows” or phases, with the first being decisive monetary policy action – a direct consequence of which would
likely be a weaker yen.
At the time of Abe’s election, the yen was trading at around ¥83 to $1.00. As of 31 March 2015, the yen had depreciated
to a level of over ¥120 to $1.00.
1
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CONSEQUENCES OF LAYERING THE YEN ON TOP OF JAPANESE EQUITIES
Since markets began anticipating the election of Prime Minister Abe around 30 November 2012, the yen has been a
significant headwind to unhedged investors. Figure 1 quantifies the impact of that headwind.
FIGURE 1: QUANTIFYING THE YEN’S HEADWIND DURING ABENOMICS
120%
92.4%
Cumulative Return
100%
80%
60%
41.6%
40%
20%
0%
-20%
-31.3%
-40%
WisdomTree Japan Hedged Equity Index (USD)
MSCI Japan Index (USD)
Yen Spot Rate (vs. USD)
Sources: WisdomTree, Bloomberg. Cumulative returns shown from 30 November 2012 to 31 March 2015.
+Japanese Equities Up Over 90% During Abenomics: The WisdomTree Japan Hedged Equity Index reflects the
actual performance of its underlying equity constituents, whereas the MSCI Japan Index includes both equity and
currency exposure. In other words, the positive equity returns of its underlying constituents were impacted by the 31.3%
depreciation of the yen – an impact made even greater due to the effect of compounding.
If there is reason to believe in Abenomics and the negative correlation between Japan’s equities and currency remains intact,
then investors should consider hedging their yen exposure. This is because the potential exists for a declining currency to
inhibit the capture of the full positive performance of the equities.
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BANK OF JAPAN ADOPTS QUALITATIVE AND QUANTITATIVE EASING
On 4 April 2013, Haruhiko Kuroda, Governor of the Bank of Japan (BOJ) announced a program of qualitative and quantitative
easing (QQE). But the BOJ took it a few steps further than other developed market central banks. Instead of confining
its purchases to fixed income, the BOJ also purchased Japanese equities (through exchange traded funds tracking the
performance of the TOPIX, Nikkei 225 and JPX Nikkei 400) as well as real estate (specifically J-REITs). The BOJ was fighting
an enemy that really hadn’t been present in other economies – deflation – the reality of what Japan’s economy had faced for
fifteen years, starting in 1998. A quote by the BOJ’s Deputy Governor, Kikuo Iwata, offered a summary of the BOJ’s rationale1:
“…market participants with rising inflation expectations will shift part of their portfolios from cash, deposits, and bonds
including JGBs to equities (including equity trust funds), real estate and homes (including real estate investment trusts
such as J-REITs) or, alternatively, foreign-denominated assets for which returns are higher than those derived from yendenominated assets. As a result of this, expectations would be for stock prices to rise, the yen to depreciate,
and foreign currencies to appreciate.”
BEST TIMES TO OWN JAPANESE EQUITIES? WHEN THE YEN WAS DEPRECIATING!
Japan has many global multinational companies. During times of yen depreciation, they can sell their goods and services
at lower prices abroad, making them more competitive. We looked to see if yen depreciation was associated with better
Japanese equity performance, thereby illustrating this intuition.
FIGURE 2: HISTORY SHOWS BETTER PERFORMANCE DURING YEN DEPRECIATION
16%
14.8%
14%
Avg. Annual Return
12%
10%
8%
6.5%
6%
3.3%
4%
2%
0%
Down Currency Trend
Up Currency Trend
Full Period
Sources: WisdomTree, MSCI. Returns measured in yen currency terms. Currency trends measured between the Japanese yen and US dollar. Down
currency trend means depreciating yen versus US dollar. Up Currency Trend means appreciation of yen versus US dollar. Full period encompasses
31 December 1969 to 31 March 2015.
+Outperformance During Trends of Depreciating Yen: From 31 December 1969 to 31 March 2015, Japanese equities,
measured in yen currency terms, returned 6.5% per year. However, during trends of yen depreciation versus the U.S.
dollar, we saw this figure jump by more than 8.0% per year to 14.8%. If one believes that the BOJ’s policy of QQE could
contribute to weakening the yen over time, historical results show how Japanese equities might respond.
1
Kikuo Iwata, “Purpose and Mechanism of Quantitative and Qualitative Monetary Easing,” Bank of Japan, 18 October 2013.
3
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THE JAPANESE YEN HAS OFFERED UNATTRACTIVE RISK/RETURN TRADEOFFS
Whether one holds the yen with Japanese equities (typical unhedged position) or opts to just hold Japanese equities (typical
hedged position), this risk/return picture can be significantly influenced.
Sharpe Ra)o FIGURE 3: EXPOSURE TO THE YEN HAS GENERALLY RESULTED IN LOWER SHARPE RATIOS
8 7 6 5 4 3 2 1 0 6.82 4.76 2.67 1.2 2.9 0.71 1.68 1.32 1 year 2.47 1.68 0.63 0.42 0.59 3 years 1.13 0.38 0.14 0.2 5 years MSCI Japan (in USD) MSCI Japan 100% Hedged to USD MSCI Japan 100% Hedged to USD (in EUR) MSCI Japan 100% Hedged to USD (in CHF) 0.42 0.38 0.01 10 years MSCI Japan 100% Hedged to USD (in GBP) Sources: Bloomberg, MSCI, Zephyr StyleADVISOR, for period 31 March 2005 to 31 March 2015.
+There was a marked decrease when comparing the Sharpe ratio of MSCI Japan, in USD (unhedged) to the Sharpe ratio
of MSCI Japan 100% Hedged to USD (hedged). This implies that for the periods observed, being exposed to currency
resulted in lower returns and/or higher risk.
+The improvement in the Sharpe ratio by being hedged to USD was also shown in other currencies and across time
periods. This was greatest for investors whose home currency is EUR, GBP and USD.
+The most recent periods show the largest impact as significant Japanese equity returns over the past two years would
have been impacted by the significant depreciation of the Yen.
The critical question: Is the detrimental impact on Sharpe ratios from holding the yen coming from decreasing returns or
increasing risk?
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FIGURE 4: AVOIDING THE YEN HAS ALLOWED FOR CAPTURE OF JAPAN’S EQUITY RALLY
Time Period
Japan
Equities
(in USD)
Japan
Equities
(in JPY)
Currency
Return
(JPY/USD)
Incremental
Returns Due
to Avoiding
Currency
Exposure
Abenomics Period*
16.1%
36.3%
-14.8%
20.2%
12.2%
15.9%
-3.7%
-0.64
3-Year
9.4%
24.0%
-11.8%
14.6%
13.0%
17.5%
-4.5%
-0.70
5-Year
5.9%
11.3%
-4.9%
5.4%
13.8%
17.9%
-4.1%
-0.65
10-Year
3.5%
4.7%
-1.1%
1.2%
15.6%
19.4%
-3.8%
-0.61
Avg. Annual Returns
Volatility
of Japan
Equities
(in USD)
Volatility
of Japan
Equities
(in JPY)
Incremental
Volatility
Due to
Currency
Exposure
Correlation
of Japan
Equities &
Currency
Return
*Abenomics Period refers to period from 30 November 2012 to 31 March 2015.
Sources: Bloomberg, MSCI, for period 31 March 2005 to 31 March 2015. Correlations and Volatility are based on monthly data.
+Abe Period Says it All: During the Abe Period, the incremental returns due to avoiding currency exposure were greater
than 20%. This “return capture” is what is driving the Sharpe ratio picture that we saw in Figure 3.
+Understanding Negative Correlations: Japan’s equities and the yen are unique of late, exhibiting significant negative
correlations over each period that we show. In other words, negative currency returns tended to be associated with
positive equity returns. This tells us that if there is a belief that Japan’s equities could rally, the historical record has
shown that this has tended to be associated with a weakening yen. Holding both the yen and Japanese equities could
therefore inhibit the full capture of Japan’s equity upside.
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INTRODUCING THE WISDOMTREE JAPAN HEDGED EQUITY INDEX
The WisdomTree Japan Hedged Equity Index is designed to focus on a pure exposure to Japanese equities without
incorporating an additional layer of currency risk. Additionally, it requires that each constituent derive less than 80% of
revenue from within Japan, thereby tilting toward exporters. The full methodology is described within Figure 5.
By hedging Yen to USD, this index may be suitable for different types of investors:
+For investors whose home currency is USD, by hedging Yen to USD, the index represents the return of Japanese
equities, while removing exposure to the Yen.
+For investors whose home currency is a currency other than USD, a USD hedged index may be suitable where you believe
USD will appreciate relative to your home currency, i.e you want to be long USD. For example, if your home currency is
EUR and USD is expected to appreciate relative to EUR, then by being hedged to USD, you would outperform a similar
product which was hedged to EUR. The reverse will be true if your home currency outperformed USD.
FIGURE 5: CONSTRUCTION OF THE WISDOMTREE JAPAN HEDGED EQUITY INDEX
Selection Rules
Eligible Universes
Component companies must be incorporated within Japan and list their shares on the Tokyo Stock Exchange.
Market Capitalization
Requirement
$100 million (in U.S. dollars)
Liquidity Requirements
1) Average daily dollar volume of at least $100,000 for three months preceding the screening date.
2) Traded at least 250,000 shares per month for each of the six months preceding the screening date.
3) A further volume screen requires that a calculated volume factor (average daily dollar volume for three months
preceding the screening date/weight of security in Index) shall be greater than $200 million.
Selection Methodology
Companies must have paid at least $5 million (U.S. dollars) in cash dividends on shares of common stock
in the annual cycle prior to the annual reconstitution. Companies also derive less than 80% of their revenues
from within Japan.
2
Weighting Rules
Weighting
Each company’s weight is proportional to its cash dividend per share paid over the annual cycle prior to the index
screening date multiplied by its shares outstanding, or Dividend Stream®3, relative to all other Index constituents.
Dividends are measured in terms of U.S. dollars.
Capping Rules
Exposure to any single company is capped at 5% of the Index prior to the introduction of sector caps. Exposure to
any single sector is capped at 25% of the Index. Between annual index screening dates, individual company and
sector weights may shift above these caps due to market movement.
Liquidity Adjustment
Factor
If a security has a calculated volume factor less than $400 million, its weight will be reduced proportionally by a
liquidity factor that equals the original calculated volume factor/$400 million. Implementation of this adjustment
may cause an increase in constituent weights above other specified caps.
Currency Hedge
Mechanics of the
Currency Hedge4
2
3
4
Local Market Japan Equity Return + Yen Return - Hedged Yen Return = Hedged Equity Return. The currency
hedging methodology consists of entering into a one-month forward currency contract in order to hedge
underlying foreign currency exposure between the U.S. dollar and Japanese yen.
Market Cap = share price x number of shares outstanding. Firms with the highest values receive the highest weights in approaches designed
to weight firms by market cap
Refers to the regular dividends per share multiplied by the number of shares outstanding
Currency hedging = strategies designed to mitigate the impact of currency performance on investment returns
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JAPAN EQUITY UCITS ETF – USD HEDGED (DXJ)
ANATOMY OF THE EXPORT TILT
One of the most interesting considerations is how the WisdomTree Japan Hedged Equity Index compares to the MSCI
Japan market capitalization-weighted benchmark in terms of sector exposure. Since greater than 97% of the weight of the
MSCI Japan Index was in firms that paid at least one dividend during the year prior to 31 March 2015, the true question is not
about dividends versus market capitalisation, but rather exporters versus domestically oriented firms.
FIGURE 6: SECTOR BETS RESULTING FROM THE EXPORT TILT
WT Japan Hedged Equity
MSCI Japan
Difference in Weight
Consumer Discretionary
25.2%
22.6%
2.6%
Consumer Staples
8.7%
6.9%
1.8%
Energy
0.4%
0.8%
-0.4%
Financials
11.0%
18.5%
-7.5%
Health Care
9.3%
6.9%
2.4%
Industrials
21.3%
19.4%
1.9%
Information Technology
14.1%
11.5%
2.6%
Materials
10.0%
6.1%
3.9%
Telecommunication Services
0.0%
5.0%
-5.0%
Utilities
0.0%
2.3%
-2.3%
+Digging into the Overweights: Consumer Discretionary, Health Care, Information Technology and Materials are the
most meaningful overweights.
+Digging into the Underweights: It’s interesting to note that focusing on global companies tends to exclude the
Telecommunication Services and Utilities sectors entirely. Additionally, Financials – one of the biggest aggregate sector
exposures within the MSCI Japan Index, was a 7.5% underweight because many of these firms do not have significant
revenues coming from outside of Japan.
WISDOMTREE JAPAN EQUITY UCITS ETF – USD HEDGED AT A GLANCE:
London Stock Exchange Code: DXJ
BBG Code: DXJ LN
Reuters Code: DXJ.L
ISIN: IE00BVXC4854
Listing Currency: USD
Fund Base Currency: USD
Financial Year End: 31 December
TER: 0.48%
Underlying Index: WisdomTree Japan Hedged Equity Index
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