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Japan's Nikkei 225 had risen by an astonishing 56.7% in 2013, which makes 2013 its best performing year since 1972. The optimism towards Japanese equities have widely been attributed as a result of "Abenomics," which takes the form of fiscal and monetary stimulus, as well as expectations of some much needed structural reforms. Despite the strong performance of Japanese equities in 2013; strong corporate earnings growth, the weakening yen and continued monetary stimulus have led to expectations of further upside in Japanese equities in 2014.

However, Japan's economy faces many significant risks, including whether the recovery could be sustained when the government raises the sales tax to 8% in April, and again to 10% in October 2015. When Japan previously raised the sales tax in 1997, the economy was plunged into a deep recession. Things may be different this time, if the government is serious with pushing through politically difficult structural reforms to promote productivity and growth.

(click to enlarge)DBJP Total Return Price Chart

DBJP Total Return Price data by YCharts

Because the Japanese yen depreciated by 17.4% against the US dollar in 2013, an investment in the popular iShares MSCI Japan ETF (NYSEARCA:EWJ) would have returned only 26.5%. Currency-hedged ETFs track the performance of foreign equity indices without the effect of currency fluctuations.

With the Fed tapering asset purchases, expectations for a stronger US dollar makes investing through currency hedged ETFs a more promising proposition. However, if instead, the US dollar depreciates against the yen, the hedged ETFs would underperform the underlying unhedged indices. The two currency hedged ETFs targeting the Japanese equity market are the WisdomTree Japan Hedged Equity Fund (NYSEARCA:DXJ) and the db X-trackers MSCI Japan Hedged Equity Fund ETF (NYSEARCA:DBJP).

The db X-trackers MSCI Japan Hedged Equity Fund ETF is the less popular of the two ETFs, but that does not necessarily mean that it is worse of the two. WisdomTree's DXJ ETF has net assets exceeding $12 billion, whilst DBJP ETF is slightly bigger than $370 million. The disparity may be partly explained by DBJP's slightly higher management fee of 0.50%, with WisdomTree's DKJ charging just 0.48%. Although the smaller size of the DBJP ETF makes the fund less liquid, which typically means that bid/ask spreads tend to be wider, the ETF has performed more strongly over the past year. In 2013, DBJP delivered investors with a total return of 49.4%, whilst DKJ would have returned only 40.9%. The significant variation in returns is because the two ETFs track different indices.

The WisdomTree Japan Hedged Equity Fund ETF tracks the performance of their own proprietary index, the WisdomTree Japan Hedged Equity Index; whereas the db X-trackers MSCI Japan Hedged Equity Fund ETF follows the MSCI Japan US Dollar Hedged Index, which is the currency hedged variant of the more popularly followed MSCI Japan Index. The MSCI Japan Index is formed from 320 constituent stocks, and covers approximately 85% of the free float-adjusted market capitalization in Japan. On the other hand, the WisdomTree Japan Hedged Equity Index consists of 342 constituent stocks, which are selected according to its own methodology.

"[The WisdomTree Japan Hedged Equity Index] consists of dividend-paying companies incorporated in Japan and traded on the Tokyo Stock Exchange that derive less than 80% of their revenue from sources in Japan. By excluding companies that derive 80% or more of their revenue from Japan, the Index is tilted towards companies with a more significant global revenue base."

Unfortunately, because of its proprietary methodology, the DXJ ETF missed out on some of the stronger stock price performances of Japan's domestically focused companies, such as Softbank, a telecommunications company, and Sumitomo Realty & Development Co., a real estate company, which rose by 189.3% and 82.4% respectively. Whilst past performance does not necessarily imply future results, the MSCI Japan Index does offer a broader exposure to the Japanese equity market. It is therefore somewhat surprising that there is so much disparity between the popularity of the two ETFs.

Source: Currency Hedged Japan Index ETFs