Those who read my articles already know that I'm very bearish on Japan (see here and here). While in the longer run I believe that Japanese equities would have to "surrender" to the lousy economic outlook and fundamentals, it's clear that in the short-run Japanese equities are greatly benefiting form the sharp decline in the value of the Japanese currency.
This is a direct result of the Japanese government's official and very loud recent policies, aiming at boosting the inflation consequently weakening the yen. I strongly recommend to short the JPY (short FXY) in the foreseeable future. The extreme fiscal and monetary steps taken by the Japanese government ensure that this is probably the safest bet in the entire currencies arena; a sort of "free lunch".
As a result of the drastic weakening of the JPY, Japanese stocks have skyrocketed. The Nikkei-225 has jumped over 12% so far this year in terms of local currency. This sharp rise in equities, however, was entirely offset by the sharp decline of the local currency. Therefore, an investor wishing to buy Japanese equities should (correction: must!) protect his holding by hedging the currency exposure.
One of the best solutions to do so easily and efficiently is the DXJ.
This ETF is a one-stop shop where on one hand it's LONG Japanese Equities and on the other hand it's SHORT the Japanese Yen (short FXY).
The DXJ is following the WisdomTree Japan Hedged Equity Index while hedging the currency exposure by selling JPY against the USD, i.e. the end result is an exposure to Japanese equities that are denominated in USD. This ETF was issued by WISDOMTREE in June 2006 and is charging 0.46% annual management fees. With an average daily volume of $55mil. it is also very liquid. Many investors are using the famous EWJ to get exposed to Japanese equities. The EWJ exposed its investors to a long position on the MSCI JAPAN index.
Until late in 2012, the DXJ behaved very similarly to the EWJ. Nevertheless, since November 2012, the two ETFs have diverged significantly, as the DXJ outperformed the EWJ by a stunning 15%! The reason for this is very simple: while the DXJ neutralized the effect of the Japanese Yen, the EWJ gave back the entire performance of the equities due to the JPY weakness. The DXJ is offering a wide-range exposure to the Japanese equity market as well as to many sectors:
As always, it's important to emphasize the risks associated with such holdings. The weakness of the JPY is fundamental. The decisions taken by the Japanese government to run a huge budget deficit through printing literally endless amounts of money is badly hurting both the independence of the Bank of Japan (BoJ) and the trade balance. The natural stance of investors is to assume that as long as the currency weakness continues - Japanese equities, at least the biggest exporters, should benefit and rise alongside the JPY decline. In the last three months, this indeed was true. Nevertheless, there is no guarantee whatsoever that this trend would keep on forever. As a matter of fact, it will most probably not last for too long!
Depreciating the value of a currency, especially as deliberately as the Japanese authorities are doing, has its toll. It doesn't come free of any less desired consequences. There are by-products and negative side effects, mainly in the form of purchasing power inequalities and decreasing purchasing power of Japanese households.
All types of exports become very expensive and this is mainly valid for energy prices. Japan, which is totally dependent on external energy products, may face extreme energy costs and this, in exchange, may reduce productivity and derail (mostly foreign) investors confidence
Investing in the DXJ allows investors to benefit from both worlds: rising Japanese equities and a declining Japanese currency. While I definitely see the JPY deteriorating further - there's simply no other way - I can't see the case for Japanese equities to move much higher, definitely not to keep up with the pace of the JPY depreciation. I don't expect the Japanese equity markets to keep on outperforming other main indices and therefore it would be wise to set an exit strategy from the current Japanese dual trend. While at the moment, the DXJ seems like the best tool to invest in the Japanese market, this may not be the case sooner than many investors may expect.