Don't Fight The Japanese Fed; How A Japanese ETF Beat The Dow Jones Industrials

| About: WisdomTree Japan (DXJ)

I recently wrote an article titled "Don't Fight The Fed: Strategy For The Coming 'Unwind'." It basically made the case that if the Fed is telling the markets what it is going to do, investors are wise to pay attention, and take them at their word. That strategy doesn't only apply to our domestic central bank, it applies to foreign central banks as well. The Japanese Central Bank has been engaged in an aggressive attempt to fight deflation, and has openly supported a weaker yen to drive exports and create inflation...yes, I said create inflation.

Last month, the government and central bank promised to work together on monetary policies until Japan achieved 2 percent inflation, a lofty goal for the country, which has been mired for more than a decade in deflation, a damaging decline in prices... But increasing the Japanese monetary supply to end deflation would also weaken the yen, which Japanese policy makers have openly welcomed as a boon to the country's exporters. That has led to grumbling from officials in the European Union and elsewhere that Japan was manipulating its currency to give its exports an unfair edge.

That policy seems to be working. While we are celebrating here in the US as most major indexes finished Q1 2013 with double digit gains, one Japanese ETF, the WisdomTree Japan Hedged Equity Fund (NYSEARCA:DXJ), soundly beat them all. By hedging the yen exposure, the fund benefited from the actions of the Japanese Central Bank. Instead of its yen exposure dragging it down, its exposure to the US dollar drove it higher. Not only did the portfolio benefit from strong equity gains in Japan, it benefited from the US dollar's gains against the Japanese yen as well. It was a one two punch that delivered some knockout returns in Q1 2013. This graphic demonstrates how DXJ (orange line) outpaced the Dow Jones Industrials (gray line), S&P 500 (blue line) and Russell 2000 (green line) by 5% or more.

Major IndexesClick to enlarge

The Japanese market as measured by the iShares MSCI Japan Index Fund (NYSEARCA:EWJ) (brown line) performed basically in line with the Dow Jones Industrials, whereas the hedged DXJ soundly beat it. The DXJ and EWJ don't use the same underlying index so it isn't a perfect example, but the performance difference is undeniable.

Jap YenClick to enlarge

The CurrencyShares Japanese Yen Trust (NYSEARCA:FXY) (gray line) was down 8% for the quarter, which more than makes up for the 6% gap between DXJ and EWJ. Had DXJ not been hedged, its return would have been 8% lower. Had EWJ been hedged, its return would have been 8% higher.

YenClick to enlarge

If an investor didn't want exposure to Japanese equities and simply wanted to capitalize on the falling yen they could sell short FXY or the iPath JPY/USD Exchange Rate ETN (NYSEARCA:JYN), or buy the 2x LEVERAGED ProShares Ultra Short Yen (NYSEARCA:YCS).

This graphic demonstrates how the various yen ETFs performed last quarter. The YCS (2x Short) was up 17%, FXY (1x Long) was down 8%, and the ProShares Ultra Yen (2x Long ) (NYSEARCA:YCL) was down 16%. Those returns could have been captured by investors by simply taking the Japanese Central Bank at its word, and selecting the appropriate investment, in this case, being short the yen.

Yen ETFsClick to enlarge

In conclusion, we are in unprecedented times; times when Central Banks around the globe are telegraphing to the financial markets their intentions. Investors should not ignore the opportunities that creates. If the opposing team hands you their playbook...take it, study it and use it to beat them. The performance of short yen funds and yen hedged portfolios are a great example of the benefits investors can get by simply listening to the Central Banks and trusting that they will do what they say.

This article addressed how to capitalize on the actions of the Japanese Central Bank. There are opportunities, but investors must also be aware of the risks. Funds like YCL and YCS are leveraged. Strategies like short selling expose investors theoretically to unlimited risk. Investing in funds like DXJ expose investors to Japanese equity risk, whereas funds like EWJ expose investors to Japanese equity AND currency risk. There are plenty of arrows in the Japanese yen quiver for investors to use, they just have to be sure to understand the risks involved before they draw and release one in their portfolio.

Disclaimer: Opinions expressed herein by the author are not an investment recommendation and are not meant to be relied upon in investment decisions. The author is not acting in an investment advisor capacity. This is not an investment research report. The author's opinions expressed herein address only select aspects of potential investment in securities of the companies mentioned and cannot be a substitute for comprehensive investment analysis. Any analysis presented herein is illustrative in nature, limited in scope, based on an incomplete set of information, and has limitations to its accuracy. The author recommends that potential and existing investors conduct thorough investment research of their own, including detailed review of the companies' SEC filings, and consult a qualified investment advisor. The information upon which this material is based was obtained from sources believed to be reliable, but has not been independently verified. Therefore, the author cannot guarantee its accuracy. Any opinions or estimates constitute the author's best judgment as of the date of publication, and are subject to change without notice.

Disclosure: I have no positions in any stocks mentioned, and no plans to initiate any positions within the next 72 hours. I wrote this article myself, and it expresses my own opinions. I am not receiving compensation for it (other than from Seeking Alpha). I have no business relationship with any company whose stock is mentioned in this article.