This popular Japan ETF has whipsawed as the yen carry trade unwinds. Here's how investors should react.

By Isabel Wang

Hello! This is MarketWatch reporter Isabel Wang, bringing you this week's ETF Wrap. In this week's edition, we look at one of the most popular Japan-focused equity ETFs, which has lost some of its luster this month after a surging yen triggered a rapid exit by investors who had relied on it to strip out currency volatilities.

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Investors unnerved by the unwinding of the Japanese yen (USDJPY) carry trade last week fled a popular equity ETF that bets on Japanese stocks while countering excessive weakness in the country's currency.

The WisdomTree Japan Hedged Equity Fund DXJ last week saw a total net outflow of over $413 million, the largest weekly outflow since January 2018, according to Dow Jones Market Data.

The fund has tumbled nearly 4% so far in August, compared with an 0.6% gain for the unhedged Invesco Currencyshares Japanese Yen Trust FXY and a nearly 3% decline for the broader iShares MSCI Japan ETF EWJ in the same period, according to FactSet data.

DXJ is designed to offer investors a currency hedge overlay on top of their Japanese equity exposure by investing in a group of export-oriented and dividend-paying firms such as Mitsubishi UFJ Financial Group (JP:8306) and Toyota Motor Corp. (JP:7203)

Yen-hedged funds are expected to do well when the country's currency weakens against the U.S. dollar DXY, and may underperform if the yen strengthens against the greenback, noted Neena Mishra, director of ETF research at Zacks Investment Research.

DXJ had been outperforming its more abundant and unhedged Japan-related ETF peers for years during the country's era of negative interest rates. But that turned on its head this month when the Bank of Japan decided to raise rates for the second time this year, which led to an appreciation in the yen.

That also hammered investors who had been borrowing the lower-yielding yen to invest in higher-yielding assets denominated in other currencies - a strategy known as a carry trade. As a result, the surging yen made DXJ and other currency-hedged ETFs less attractive compared with their unhedged rivals.

See: S&P 500 erases August losses as 'irrational recession fears' fade

Global financial markets have since rebounded, and the meltdown earlier this month now looks more like a brief tremor - but the way it unfolded highlights the volatility of the Japanese yen and how fragile investors could be amid wild swings in the foreign-exchange and stock markets.

Since Aug. 5, the Japanese yen has weakened 4.6% against the U.S. dollar to trade at 149.03 at the time of writing Thursday afternoon. The Nikkei 225 index JP:NIK, meanwhile, has since erased all its losses suffered during the Aug. 5 plunge. In the U.S. market, the S&P 500 SPX surged on Thursday to give back all its declines from earlier in the month, according to FactSet data.

See: Stocks still vulnerable to further unwind of yen carry trade, strategists say

However, there are still concerns that the unwinding of the yen-based carry trade could drive further losses.

"The situation is unusual as of now, and there are a lot of uncertainties," Mishra told MarketWatch via phone on Thursday. "We do not know how many of those yen carry trades have been unwound, and in the U.S. [we don't know] when and how much the Fed would cut interest rates given the mixed economic data."

Mishra noted that because currency movements are cyclical, they could "cancel out" over time, but in the shorter term are "almost impossible" to predict.

That is why she suggests investors consider a "50-50" approach when investing in Japan-related ETFs - by putting half of their assets in one of the currency-hedged funds like DXJ and another half in some of the "cheaper" unhedged funds, such as the Franklin FTSE Japan ETF FLJP and the JPMorgan BetaBuilders Japan ETF BBJP.

See: Opinion: Your stocks now trade at the mercy of the Japanese yen

Time to take off the currency hedge?

WisdomTree's Jeremy Schwartz, the ivnestment manager's global chief investment officer, and Jeff Weniger, its head of equity strategy, said a currency-hedged Japan position should outperform the S&P 500 over the next few years.

The forward 12-month earnings per share (EPS) for the S&P 500 is $277.50, which means its earnings yield is hovering at 5% after dividing the EPS by the index's closing price of 5,543.22 on Thursday.

Adding expected inflation of 2% to 3%, the medium-term return estimate for the S&P 500 would be 7% to 8%, Schwartz and Weniger said in a client note from last week.

Meanwhile, the forward 12-month EPS for DXJ is $9.10, which takes its earnings yield to 8.6% after dividing by its share price of $105.69 on Thursday.

"The carry from the currency forward contracts is above 5% at the moment, but it is now everyone's base case that the Fed and BoJ will change that, so we price in a slide in this gap between the U.S. and Japanese short rates to around 3% in 2025," the analysts said.

As a result, the medium-term return for DXJ would be around 12% after adding the approximated 3% carry in 2025, they wrote.

Additionally, history shows that Japanese equities usually perform well after a brutal three-day decline (see table below). In the three-day period ending Aug. 5, the Nikkei 225 fell nearly 20% to suffer its worst three-day decline on record, according to Dow Jones Market Data.

"After the earlier crashes, the median subsequent 12-month stock-market return was 10.9% and the average was 14.6%. This includes the miserable 1990 experience, when Japan's bubble was bursting," Schwartz and Weniger wrote. "If we draw a line through 1990, which we think is reasonable given the stock market's bubble status at the time, that makes the lookback even more compelling.

"As with many market crashes, buying after a panic is generally a profitable move," they added.

As usual, here's your look at the top- and bottom-performing ETFs over the past week through Wednesday, according to FactSet data.

The good...

   Top performers                                                                                                                                                                    %Performance 
   YieldMax NVDA Option Income Strategy ETF                                                                                                                                          7.1 
   VanEck Junior Gold Miners ETF                                                                                                                                                     5.9 
   Amplify Junior Silver Miners ETF                                                                                                                                                  5.8 
   iShares MSCI Global Gold Miners ETF                                                                                                                                               5.7 
   iShares MSCI Brazil ETF                                                                                                                                                           5.6 
   Source: FactSet data through Wednesday, Aug. 14. Start date Aug. 8. Excludes ETNs and leveraged products. Includes NYSE, Nasdaq and Cboe traded ETFs of $500 million or greater. 

... and the bad

   Bottom performers                     %Performance 
   KraneShares CSI China Internet ETF    -2.1 
   Invesco China Technology ETF          -2.1 
   Global X Lithium & Battery Tech ETF   -2.0 
   U.S. Global Jets ETF                  -1.6 
   Alerian MLP ETF                       -1.6 
   Source: FactSet data 

New ETFs

Rockefeller Asset Management on Wednesday announced its expansion into opportunistic municipals with the launch of three actively managed ETFs: Rockefeller Opportunistic Municipal Bond ETF RMOP, Rockefeller California Municipal Bond ETF RMCA and Rockefeller New York Municipal Bond ETF RMNY. Janus Henderson Group on Wednesday launched the Janus Henderson Emerging Markets Debt Hard Currency ETF JEMB. The fund aims to invest in a diversified portfolio of sovereign, quasi-sovereign, supranational and corporate debt from EM issuers, the firm said in a press release.TappAlpha on Thursday launched its SPY Growth & Daily Income ETF TSPY, which is designed to combine the growth potential of the S&P 500 with a daily covered call (0DTE) strategy, the company said in a press release.

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-Isabel Wang

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08-15-24 1820ET

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