Currency Rates and Japan

Japanese Market and Currency Swings

The Japanese stock market has been rallying, although recent losses have been in the headlines. Lets use this rally to provide us a stark example of the impact of currency rates on your portfolio.

As part of a policy from the Japanese government to spur growth, their currency has been allowed to depreciate 25% over the last 6 months. If you go to any typical financial site on the web you can see the ratio of the US Dollar to the Japanese Yen or follow the ticker “JPY” which is the ratio of the Yen / Dollar. The Japanese Yen was .013 per USD in October, 2012 and is now at a ratio of .0098 per USD as of May, 2013.

Now let’s look at the gain in stock prices. The Japanese Nikkei 225 index, which peaked at 38,916 in January of 1990, was around 10,000 in January 2011. The index reached 14,000 recently, for a gain of approximately 40% in local currency terms.

Anyone would want to participate in a 40% stock market rally, right?

Well, results can vary. EWJ, an iShares ETF covering the Japanese market, is “unhedged”. Thus if you invest you get the local market appreciation (the 40% gain) but this is offset by any currency moves, which means that you lose 25% when you put it back into US dollars. Let’s do a (very simplified) math problem here:

– $100 worth of US investment gains 40% in local currency terms = $140
– Take that $140 and multiply it by 75% (to reflect the 25% loss in currency) and you now get $105 USD
– Thus your gain in USD terms, after the currency change is 5% ($105-$100 / $100)

Due to a number of factors the math doesn’t work that simply so let’s show some real world examples.

Performance of Unhedged (EWF) and Hedged (DXJ) ETF’s

EWF is the “unhedged” ETF for the Japanese market, and DXJ is the “hedged” ETF for the Japanese market (meaning that they buy enough USD derivative offsets to adjust performance against currency moves in the US dollar).

Over the last year the DXJ returned around 50% while EWJ returned 20%. This article describes the battle for market share between the two funds, which DXJ (the hedged one) seems to be winning in the near term.

For many years the Japanese Yen APPRECIATED against the US dollar, so this is a reversal of long term trends. If you’d have used the hedged ETF all those years ago you would have had the opposite results. Hedging is great when the US dollar is appreciating, but goes the opposite when the dollar is falling. Note too that in the long term hedging an ETF is more costly than leaving it in an unhedged state, although this premium is not that large.

Simpler Example – A Single Stock

Let’s look at a simpler story – Nidec, a Japanese manufacturer, has been a stock we selected for Portfolio Two and held it for several years. The ADR for this stock is NJ, and its “underlying” stock on the Tokyo Stock Exchange has the symbol 6594. The two stocks should trade very close to lock step, and the only significant difference in value should be caused by currency swings. Over the last six months

– 6594 on the Japanese exchange (denominated in Yen) has had a positive return of 29%
– NJ, an ADR on NYSE (denominated in dollars) has had a positive return of 10%

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