DXJ: A Great Fund At A Bad Price (NYSEARCA:DXJ)

Japanese stocks have been one of the best investments outside the US in recent years. Funds like the WisdomTree Japan Hedged Equity Fund ETF (NYSEARCA:DXJ) provide exposure without having to worry about Yen movements and expensive hedges.

However, all good things come to an end, or at least pause for a while, and with the Nikkei now at its previous all-time high from 1989, Japanese stocks are up against formidable resistance and DXJ may struggle to hold on to its gains.

DXJ Overview

DXJ is a passively managed ETF with $4.19B AUM and an Average Daily Dollar Volume of $99M. According to the Fund Page, DXJ “seeks to provide exposure to the Japanese equity market while hedging exposure to fluctuations between the U.S. dollar and the yen.”

The Yen is -8.81% lower against the US dollar this year and is a volatile currency, so the hedge is a welcome addition, although it does add to expenses. On that matter, the expense ratio is 0.48%, which is on the high side for a passive ETF, but not prohibitively so.

The Index is composed by a rules-based methodology, which is quite complex but can be boiled down to –

The Index consists of dividend-paying companies incorporated in Japan and traded on the Tokyo Stock Exchange that derive less than 80% of their revenue from sources in Japan. By excluding companies that derive 80% or more of their revenue from Japan, the Index is tilted towards companies with a more significant global revenue base.

Industrials feature highly in the sector breakdown, which is a change from the technology heavy ETFs in the US.

The top 10 holdings look like this –

The portfolio is well diversified. The top 10 holdings make up 32% of the portfolio, which is lower than many other funds. Moreover, the fund holds 443 stocks.

A dividend of 2.5% is paid quarterly, and this has been growing every year since 2019.

DXJ Performance

The rest of the world has generally underperformed US stocks and the S&P500 (SPY). However, that is not the case with Japan, or with DXJ, at least over the last three years.

Much of this outperformance can be attributed to the collapse in the Yen. When DXJ is compared to a similar unhedged fund such as the iShares MSCI Japan ETF (EWJ), the difference is significant. Note how the two funds correlate and have similar returns until late 2021 when the Yen collapses.

Just to clarify, USD:JPY has gained around 50% since the 2020 low; a huge move in currency terms.

The collapsing Yen is a major tailwind for DXJ, but even when this is taken out of the equation, its performance is impressive. There are five other currency hedged ETFs with a focus on Japan, and DXJ is the top performer on almost every timeframe.

3 Reasons to be Careful

While DXJ has performed well and has all the attributes of a good fund, there are three reasons to be careful and perhaps wait for a better entry.

1. One of the reasons for the large rally in Japanese stocks comes from retail buying (and less retail selling). This has been stimulated by an increase in the limits Japanese retail investors can invest in a tax-free account – a change aimed at boosting household wealth and encouraging households to invest in riskier assets such as stocks. While this has had a positive effect in the near-term, increased retail buying is usually a red flag. Indeed, the Nikkei 1989 top was formed as institutions distributed to speculating retail investors.
2. As already noted, the collapse in the Yen has been a major tailwind for DXJ. However, the move looks stretched and the Bank of Japan have finally started to tighten financial conditions. Last month, the bank made its first hike in 17 years and ended the era of negative interest rates. Meanwhile, the Fed look set to cut rates this year. The diverging policies suggest the USD:JPY rally should run out of steam.
3. The Nikkei has reached its previous 1989 peak, which could act as resistance.

After an initial break-out and surge to 41,087, it has now dropped back below the previous peak of 38,960 to trade at 38,471.

When an equity market returns to a previous all-time high after many years at lower highs, it often struggles to break above cleanly. Examples come from the Nasdaq Composite Index (COMP:IND) –

The FTSE –

And the Hang Seng –

All these equity markets experienced drawdowns of varying degrees following a failed break to new all-time highs. Of course, we don’t know if the Nikkei will do something similar, but these charts do suggest caution.

Conclusions

DXJ has all the attributes of a good fund, and its performance is impressive. However, I do have reservations about buying at current levels. Japanese stocks could roll over at major resistance, and the collapse in the Yen may have run its course. DXJ will be on my shopping list should a large correction unfold, but I won’t be a buyer in Q2.

Editor’s Note: This article covers one or more microcap stocks. Please be aware of the risks associated with these stocks.