2023-12-27 15:54:58 ET
Summary
- Going long Japanese equities and short the yen has proven to be a winning trade.
- There's a new regime in place, however, and the winds may not be as favorable to a hedged Japan equity strategy over the next decade.
- Valuations also screen richly after a standout 2023, potentially limiting future equity upside and in Xtrackers MSCI Japan Hedged Equity ETF.
As strong a year as 2023 has been for Japanese large-cap exchange-traded funds, or ETFs, hedged versions like the low-cost Xtrackers MSCI Japan Hedged Equity ETF ( DBJP ) have performed even better. To some extent, the rally has been supported by fundamental tailwinds - economic growth is down, but inflation has returned (without a "wage-price spiral"), and earnings growth has benefited. Perhaps most importantly, though, was the Tokyo Stock Exchange's ((TSE)) latest push for reform in a market well-known for shareholder-unfriendly corporate governance. Results have been mixed so far, but reforms are beginning to gain traction in all the right places - a notable recent event being the further unwinding of Toyota's cross-shareholdings (worth as much as $40bn) via a sale of its stake in supplier DENSO (DNZOF). Further moves toward improving capital efficiency (both for investments and shareholder return) bode well for equity performance going forward.
That said, Japanese equities are not priced cheaply - following this year's re-rating, large-caps now trade at a low-teens forward earnings multiple. Yet, little in the macro and micro supports this re-rate. Q3 data indicates further stagnation in the Japanese economy, while external demand weakness could add downward pressure on consensus earnings (currently at +11% in 2024 and +7% in 2025).
On the valuation side, stocks will also have to navigate monetary policy normalization by the Bank of Japan ((BOJ)), as well as yen appreciation. Any reversal of the weak yen tailwind over the last decade will likely be gradual ; when it eventually hits, though, hedged ETFs like DBJP are poised to suffer a double whammy of lower valuations and losses from currency hedging. Net-net, I like the value of unlocking optionality in Japanese stocks but remain skeptical about the sustainability of the pace of this Japanese rally going forward.
Xtrackers MSCI Japan Hedged Equity ETF Overview - Hedged Exposure to Japanese Large-Caps at a Competitive Price
The U.S.-listed Xtrackers MSCI Japan Hedged Equity ETF tracks (pre-expenses) the total return performance of the MSCI Japan US Dollar Hedged Index, a basket of large-cap Japanese stocks hedged against yen depreciation via a USD/JPY forward contract. On the back of this year's outperformance, the fund now manages a ~$295m asset base - larger than the key ETF comparable, the iShares Currency Hedged MSCI Japan ETF (HEWJ). DBJP also boats a very competitive 0.47% expense ratio - below both the ~1% gross expense ratio and ~0.5% net of fee waivers (through 2025) charged by HEWJ.
That said, DBJP is the less liquid of the two, as reflected in its wider bid-ask spread (0.18% vs. 0.03% for HEWJ), so those trading in size should consider the execution costs as well.
Like other MSCI Japan trackers, DBJP's aggregate 229-stock portfolio is skewed to export-oriented names in sectors like Industrials (20.1%), Consumer Discretionary (19.5%), and Information Technology (17.0%). The more domestic-oriented Financials sector is a meaningful portfolio contributor at 12.4%, while Health Care (8.4%) rounds up the top five list. By comparison, the closest alternative HEWJ has a similar composition but is slightly more top-heavy, with a larger allocation to its top sectors, Industrials, and Consumer Discretionary. Both funds do, however, share a defensive profile - per its latest factsheet , DBJP's equity beta (i.e., the underlying volatility vs. the broader market) stands at ~0.7.
In line with Japan's export-oriented economy, the DBJP single-stock allocation skews toward blue-chip exporters. At the top of the list is automotive manufacturer Toyota Motor ( TM ) at 5.3%, followed by tech/media company Sony Group ( SONY ) at 3.3%, and financial services leader Mitsubishi UFJ ( MUFG ) at 2.8%. Factory automation company Keyence ( KYCCF ) remains in the top five despite its H2 2023 decline, while electronics/semiconductor company Tokyo Electron ( TOELY ) continues to gain share after a standout year. For the most part, the single-stock composition is in line with other MSCI Japan trackers (hedged and unhedged). Similarly, the DBJP portfolio is priced at a re-rated ~14x forward earnings (~15x trailing) and a ~50% premium to book value - not cheap by historical levels or relative to underlying growth.
Where DBJP stands out, though, is its relatively simple currency hedge book, comprising one USD/JPY (USD:JPY) contract at the one-month forward rate. HEWJ, in contrast, spreads its hedges across multiple forward contracts and cash equivalents (e.g., money market fund holdings) - potentially a driver of its higher expense ratio vs DBJP. Hedging is also key as it affects leverage levels, with DBJP running a lower 101.9% net long exposure (vs. 103.4% for HEWJ). DBJP's approach might hinder performance during bull markets but, inversely, offers better downside protection through a bear cycle.
Xtrackers MSCI Japan Hedged Equity ETF Performance - A Golden Decade for the Long Japan/Short JPY Playbook
It's been another great year for DBJP, with year-to-date total returns further outpacing unhedged MSCI Japan trackers at +33.0%. Since its inception in 2011, the fund has now compounded at an impressive +11.2% annualized pace (market price and NAV terms) - more than double the unhedged returns. A large chunk of the returns has notably come in recent years - DBJP's overall returns stand at a higher +15.7% and +12.2% over the last three and five years, respectively, boosted by accelerated yen depreciation. Key comparable HEWJ has delivered similarly strong returns, though its higher leverage has granted it slightly higher returns this year. For the most part, though, both ETFs track their underlying indices fairly well.
As impressive as a long Japan/short JPY strategy has been over the last decade, there are potential drawbacks to consider. For one, this outperformance has benefited from a period of extreme monetary easing under a different regime ("Abenomics"). With a change of guard at the government and central bank, investors should be wary of underwriting a similar pace of capital returns going forward. Plus, this hasn't historically been a great fund for income (H1 2023 distribution aside), and I wouldn't underwrite upside to sub-1% yields going forward.
A Riskier Outlook for the Hedged Japan Playbook
Over the last decade, the long Japanese stocks/short yen pair trade has paid off handsomely - on a YTD basis, DBJP has returned +33%. But things are changing, albeit very gradually, now that the BOJ is normalizing monetary policy. That probably means the old playbook may need to be thrown out - higher rates and an appreciating yen would hit DBJP in both directions (via equity valuations and currency hedges).
To be clear, there are mitigating factors for owning Japanese equities, most notably from a renewed push for governance reforms, which could unlock a fair bit of shareholder value. Relative to a mid-teens earnings multiple (vs. high-single-digits % earnings growth through 2025), on the other hand, a lot of the positives seem priced in here. Adding to the hurdles are potential risks on the macro front, including slower domestic and external growth. On balance, I remain sidelined on DBJP at these levels.
For further details see:
DBJP: A Riskier Outlook For The Hedged Japan Playbook