Review & Outlook

Our take on the investing, financial, & economic themes of the day

The Investment Perils and Promise of Currency Manipulation

3 January, 2014 by Matthew O'Brien, Ph.D. in Commentary

About 40% of sales from companies in the S&P 500 Index come from their businesses in international markets, so an investor who buys American companies has greater exposure to foreign economies than he might realize.  Our clients’ equity holdings are primarily U.S.-listed stocks, but we sometimes buy country-specific exchange traded funds (ETFs) in order to provide greater exposure to specific foreign markets, and to hedge to a small degree against the fortunes of the U.S. dollar.

 One of the funds we have bought is iShares MSCI Japan (EWJ).  The best-performing developed stock market in 2013 was Japan.  The Nikkei closed out the year at its highest level since November 2, 2007 and its 57% gain marked the best single year since 1972.  EWJ was up only 21.5%.  Why the big discrepancy?

Finding the answer requires learning more than you may have wanted to know about FX and the mechanics of exchange-traded funds.

The primary reason why EWJ lagged the Nikkei is the weakening of the yen relative to the dollar.  In 2013 the yen dropped 21% against the dollar.  Since EWJ is denominated in dollars, its shareholders had to face a big currency headwind when their underlying investment is translated from yen back to dollars.  The reason for the yen’s devaluation is the same reason for the Nikkei’s banner year in stock gains: the Bank of Japan’s massive quantitative easing program (QE).

Japan’s QE has been smaller than the Federal Reserve’s QE in absolute terms, but much bigger relative to the size of its domestic economy.  Back in April when the Bank of Japan announced its “new phase” of QE, it said that it would double Japan’s monetary base from Y135 trillion ($1.43 trillion) to Y270 trillion by December 2014.  Although its chief means has been purchases of long-term government bonds, Japan’s QE has even included stock purchases as well.  Before the Federal Reserve’s (miniscule) taper decision last month, its QE had been increasing the Fed’s balance sheet by about 0.5% of GDP per month, while Japan’s QE has been increasing its central bank’s balance sheet by about 1.0% of GDP per month.

The effect of Japan’s QE has been to ignite the Nikkei and devalue the yen, both of which reward Japan’s big corporations handsomely, especially the exporters.  These corporations get a higher stock price as Japanese savers are pushed out of bonds and into stocks and as international speculators amplify the rise by descending on Japanese equities looking to ride the QE-induced surge.  Furthermore, thanks to the magic of currency manipulation, Japanese exporters suddenly become much more profitable.

It’s dubious whether inducing a stock surge and devaluing the yen is really going to help Japan in the long run.  As Henny Sender of the Financial Times argued last year, even with a weaker yen, “the world’s consumers are not about to abandon Samsung gadgets for those of Sony or Toshiba.  The problem is not an uncompetitive currency, it is uncompetitive products.”  I would add that Japan is also uncompetitive in the most basic and lasting form of capital investment: children.  In 2013 Japan’s population declined by the greatest number of people ever, and its rapidly aging population is projected to shrink by 25% by 2050, at current rates.  (The U.S. population is projected to grow 34% over the same period.)

When we started buying country-specific ETFs, currency hedging wasn’t an option.  Our relatively simple strategy has been to pick countries with an attractive macroeconomic profile and funds with holdings in the high-quality companies of those countries.  We figured that currency exchange would sometimes help and sometimes hurt.  Thus compare how the Swiss Franc strengthened against the dollar in 2013 (the iShares MSCI Switzerland Capped ETF [EWL] is another fund we hold for our clients), as the yen depreciated.


The advent of hedged ETFs a few years ago has allowed investors to speculate on where they think currency exchange is headed in addition to foreign market stock performance.  If you made the political bet at the end of 2012 that Japan’s central bank would discard its traditional policy and start bond-buying on a massive scale, and the yen would thus weaken, then you could have bought a Japan ETF hedged accordingly.  You would have made even more money than holders of plain vanilla, un-hedged Japan ETFs.  Compare the superior returns of DXJ, which is the more popular of two available hedged Japan ETFs, with EWJ.


iShares MSCI Japan (EWJ) vs. WisdomTree Japan Hedged Equity (DXJ)


But if you had chosen to buy the other available Japan ETF that hedges for a weakening yen, DBJP, then you would have done even better.


db X-trackers MSCI Japan Hedged Equity (DBJP) vs. WisdomTree Japan Hedged Equity (DXJ)



DBJP’s beating out DXJ demonstrates the difficulty of getting currency speculations right.  For if you wanted a currency-hedged Japan ETF on the assumption that the yen was going to weaken, then you should have bought DXJ and not DBJP.  This is because DXJ, which is managed by the innovative and successful fund company WisdomTree, tracks a proprietary index that tilts fund holdings towards companies inclined to benefit especially from a weakening yen.  WisdomTree’s proprietary index includes a filter to screen out companies that have more than 80% of their revenue generated within Japan, since such domestically-oriented companies don’t benefit from a manipulated exchange rate.  DBJP tracks an MSCI index—the same one tracked by the fund we have owned, iShares’ EWJ.  The MSCI index is a simpler, market capitalization weighted index that just tracks listed Japanese companies, willy-nilly.

So the same rationale that would have led you to outperform with an investment in DXJ instead of EWJ would have led you to underperform with DXJ instead of DBJP.


Matthew B. O’Brien, Ph.D.