Over the past few years, investors that have taken a chance on the iShares MSCI Japan Index (NYSEARCA:EWJ) have been rewarded by the appreciating yen against the U.S. dollar. As the yen has started to weaken, exchange traded funds that hedge foreign currency exposure could be a better choice.
"The near-term outlook for corporate Japan might finally be improving. Aside from the falling yen, other positive trends include an improving U.S. economy, relatively healthy Asian economies (a growing major export destination for Japanese products), and post-quake-related spending. These factors should support significantly better earnings in the next fiscal year (which ends March 2013)," Patricia Oey for Morningstar wrote in a recent article.
The Bank of Japan recently boosted its asset purchase program with an inflation target of 1%, creating a headwind for the Japanese yen. In turn, Japanese large-cap companies have spurred a rally because most of them are exporters to several countries.
"From January 2007 to December 2011, the yen rose more than 50% against the U.S. dollar. These factors weighed heavily on a stock market tilted toward cyclical stocks," Oey wrote.
Investors can reduce the risk of loss from fluctuations in exchange rates by hedging with foreign currency. Hedging simply involves taking on risk to offset another. Foreign currency risk comes from potential changes in the exchange rate of one currency in relation to another.
DXJ hedges its Japanese yen exposure by holding currency forward and futures contracts. EWJ does not hedge currency risk.
WisdomTree Japan Hedged Equity
Tisha Guerrero contributed to this article.
Disclosure: I have no positions in any stocks mentioned, and no plans to initiate any positions within the next 72 hours.