By Jeremy Schwartz
In the last year, there has been a tremendous amount of investor flow into, appetite for and discussion of the low-volatility factor of investing, along with high-dividend stocks such as utilities. The Dow Jones U.S. Select Dividend Index, for instance, has more than one-third of its exposure in utilities and has seen a return that was double the S&P 500 return through August 31. Low-volatility and minimum-volatility strategies have also been outperforming and have been the leading recipient of investor flows.
Japan has been on the opposite end of the spectrum. While the S&P 500 was up more than 7% through August, the WisdomTree Japan Hedged Equity Fund (NYSEARCA:DXJ) had a return of -14.09%. Investors have viewed Japan as a more cyclical exposure to the global economy, and global investors have been reducing exposure to Japan on the back of a strengthening yen. Click here for standardized performance of DXJ.
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In my opinion, the outperformance of low-volatility and high-dividend strategies and underperformance of Japan are two sides of the same coin and are driven by the same fundamental force: a declining U.S. interest rate environment that saw the U.S. 10-year yield decline from more than 2.2% at the start of the year to a low of 1.36% on July 8.
The Turning Point: July 8
However, since July 8, two things have happened:
- Interest rates bottomed and started to rise from their lows following stronger jobs reports in the U.S.
- Japanese Prime Minister Abe recorded a major political victory that saw his party and coalition win the upper house elections, and he received a bigger mandate for governing Japan. He has since passed a fiscal stimulus plan to support the economy.
Since that bottom of interest rates and the upper house victory on July 8, low-volatility and high-dividend stocks have reversed their year-to-date strong performance and started to underperform the S&P 500, and Japan has outperformed significantly, by more than 10 percentage points from July 8 to August 31.
How Much Interest Rate Risk Do You Have in Your Equity Portfolio?
Investors who have been embracing the low-volatility/high-dividend/utilities sector trade should be aware of how much "bond duration" or interest rate risk they may have added to their portfolios. If interest rates continue to rise, these three areas of the market could face a tough period of performance and compound poor returns from bond-like allocations, in our view.
One of the best hedges for rising interest rates in the U.S. is Japanese equity exposure. Japanese companies are very exposed to the U.S. economy-it is one of their biggest profit centers. A strengthening U.S. economy that supports rising U.S. interest rates is one of most supportive fundamental drivers of Japan. A strengthening U.S. economy also hurts these lower-volatility and utilities-oriented equity exposures in U.S. markets, which are fairly interest-rate-sensitive and more expensive than normal today.
For those investors like me who think the low-volatility trade of 2016 ended on July 8, I would add positions to Japanese equities, particularly on a currency-hedged basis, as that also may have marked the bottoming of Japanese equities' underperformance. Again, I view these as two sides of the same interest rate coin. If rates bottomed, so too did Japan.
Unless otherwise noted, data source is Bloomberg, as of 8/31/16.
Important Risks Related to this Article
There are risks associated with investing, including possible loss of principal. Foreign investing involves special risks, such as risk of loss from currency fluctuation or political or economic uncertainty. The Fund focuses its investments in Japan, thereby increasing the impact of events and developments in Japan that can adversely affect performance. Investments in currency involve additional special risks, such as credit risk and interest rate fluctuations. Derivative investments can be volatile, and these investments may be less liquid than other securities, and more sensitive to the effects of varied economic conditions. As this Fund can have a high concentration in some issuers, the Fund can be adversely impacted by changes affecting those issuers. Due to the investment strategy of this Fund, it may make higher capital gain distributions than other ETFs. Please read the Fund's prospectus for specific details regarding the Fund's risk profile.
Jeremy Schwartz, Director of Research
As WisdomTree's Director of Research, Jeremy Schwartz offers timely ideas and timeless wisdom on a bi-monthly basis. Prior to joining WisdomTree, Jeremy was Professor Jeremy Siegel's head research assistant and helped with the research and writing of Stocks for the Long Run and The Future for Investors. He is also the co-author of the Financial Analysts Journal paper "What Happened to the Original Stocks in the S&P 500?" and the Wall Street Journal article "The Great American Bond Bubble."