Japan’s Catch-22 could snag U.S. investors

The Bank of Japan’s latest effort to stimulate the country’s economy might be good for its stock market, but it leaves U.S. investors in a pickle.

The bank recently said it would begin an open-ended asset purchase program, similar to the Federal Reserve’s third round of quantitative easing. While the move is likely to bolster risk assets, as QE3 did in the U.S., it will do so at the cost of a weakening yen.

And a depreciating yen will take a big bite out of any gains U.S. investors reap from Japanese stocks. That could be a big problem for advisers looking to make a tactical allocation to take advantage of the new policy.

That’s because the majority of exchange-traded funds that focus solely on Japan don’t hedge out the currency, and for good reason, said Matt Hougan, president of IndexUniverse LLC.

“Traditionally, you really want the currency,” he said. “That’s where the majority of international stock’s diversification comes from.”

The ferocity of Japan’s pledge to devalue its currency makes it an unusual case, Mr. Hougan said.

“They’ve been very direct that it’s the goal,” he said.

The $2.29 billion WisdomTree Japan Hedged Equity ETF (DXJ) is the only ETF currently available that hedges out yen exposure. Advisers also can hedge out yen exposure in the other available Japan-centric ETFs through futures contracts.

Since the yen started falling against the dollar in anticipation of Japan’s quantitative easing program in mid-November, the hedged ETF has almost doubled the return of the unhedged ETFs.

From Nov. 14, when the yen’s 20% slide vs. the U.S. dollar began, through Jan. 25, the WisdomTree ETF is up 26%. The $5 billion iShares MSCI Japan Index ETF (EWJ) is up 12.6% over the same period. Both funds have had more than $1 billion of inflows over the last two months, according to IndexUniverse data.

Of course, if the yen were to begin appreciating again, the WisdomTree ETF would more than likely be an ETF that underperforms. In 2010, for example, the yen rallied 10% against the dollar. WisdomTree’s ETF lost almost 2% that year, while the iShares ETF gained 13%.