Navigating Japanese equities: Strategies for hedging JPY exposure Navigating Japanese equities: Strategies for hedging JPY exposure Navigating Japanese equities: Strategies for hedging JPY exposure

Navigating Japanese equities: Strategies for hedging JPY exposure

Forex 10 minutes to read
Charu Chanana

Market Strategist

Summary:  Investing in Japanese equities presents lucrative opportunities amid recent market highs and a diverse industry landscape, although foreign investors could face challenges due to FX exposure. Hedging via forward contracts, options, or currency ETFs, however, can mitigate FX risk. Moreover, positive carry makes hedging cost-effective and can help investors to focus on the underlying fundamentals of Japanese stocks without being exposed to currency fluctuations.


Japanese equities have been a focal point for global investors seeking growth opportunities and portfolio diversification, and Nikkei 225 has recently breached its 35-year highs to climb to fresh record highs.

With the world's third-largest economy boasting a rich tapestry of industries ranging from automotive and technology to healthcare and finance, Japan offers an array of investment options for discerning investors.

However, while the potential rewards of investing in Japanese stocks are enticing, navigating the intricacies of foreign exchange (FX) exposure remains a critical challenge as fluctuations in FX can significantly impact the returns of foreign investors holding Japanese stocks, adding an extra layer of complexity to their investment decisions. But appropriate hedging strategies can help investors optimize their portfolios for long-term success in the Japanese market.

Why invest in Japanese equities?

The returns of Nikkei 225 have outpaced S&P 500 since the start of last year. Source: Bloomberg

Japan is a market where macro meets momentum. Despite the challenge of an aging population, Japanese companies have boasted of large global operations and technological innovation along with a stable regulatory environment. Some of the other tailwinds that have contributed to fresh highs in the Japanese equity markets include:

  1. Weak Japanese yen: A weak yen can benefit Japanese exporters by making their goods more competitively priced in international markets, thereby boosting export revenues and profitability. It also increases the value of foreign earnings when converted back into yen, potentially leading to higher profits for multinational Japanese companies.
  2. Negative/low interest rate: Japan is the only major economy that has negative interest rates. Despite expectations of normalization for Bank of Japan (BOJ), we do not expect any significant increases to interest rates, which will continue to facilitate access to low-cost capital for corporates. This environment incentivizes borrowing for investment and expansion purposes, allowing Japanese companies to fund growth initiatives at favourable terms.
  3. Corporate governance reforms: Japan has implemented significant corporate governance reforms aimed at enhancing transparency, accountability, and shareholder rights. These reforms include measures to strengthen board independence, increase disclosure requirements, and promote shareholder activism, all of which improve investor confidence and corporate performance.
  4. Return of inflation: The exit from deflation in Japan has given pricing power to corporates which is helping to expand profit margins and increase capex spending. This is a start of a positive feedback loop as higher wages could drive up inflation further.
  5. Valuation discount: Japanese equities have long traded at a valuation discount compared to their global peers, presenting opportunities for value investors to acquire quality assets at attractive prices. This valuation gap may be due to factors such as perceived corporate inefficiencies, cultural differences, or historical market biases, providing potential for upside as market perceptions change. Despite the recent run higher in Japanese equities, the chart below shows that Nikkei 225 trades at a 12-month forward EV/EBITDA of 11.7x compared to that of S&P 500 at 13.8x. Strong earnings momentum is also justifying the recent multiple expansion.
  6. Geopolitical risks: Japan's geopolitical position in Asia has historically been a stabilizing force, contributing to regional peace and security. The country's strategic alliances and diplomatic relationships have provided a peaceful alternative in the new normal of escalating geopolitical tensions. Geopolitical stability can attract foreign investment and foster confidence among domestic businesses.
  7. Tech innovation: Japan is at the forefront of technological innovation, particularly in sectors such as robotics, artificial intelligence, and renewable energy. Investments in Japanese companies at the forefront of these technological advancements offer exposure to cutting-edge innovation and potential for significant long-term growth and profitability, especially in the current AI boom.
  8. Warren Buffet’s nod: Warren Buffett, renowned investor and CEO of Berkshire Hathaway, has expressed confidence in the long-term prospects of Japanese equities. His investment in Japanese trading companies and positive remarks about the country's investment potential have bolstered investor sentiment and drawn attention to the opportunities in the Japanese market.
  9. Low interest rate sensitivity: The balance sheet of Japanese equities tends to be net cash (or, negative net debt or higher cash levels relative to debt) given the prolonged low interest rate environment. This means that Japanese companies actually have a positive sensitivity to rising interest rates unlike most other equity markets including the US equity market.
  10. The case for diversification: Investors exposed to the Japanese equity market get an overweight to industrials and consumer discretionary sectors and a significant underweight in the information technology sector. This has made Japanese market a key consideration for those looking to diversify away from a large exposure to the Magnificent 7 US stocks. Domestic investors have also had a compelling reason to diversify their larger bond holdings and shift portfolios towards equities as risks of normalization from Bank of Japan continue to take hold.
12m Forward EV/EBITDA for Nikkei 225 vs. S&P 500. Source: Bloomberg

These range of tailwinds have meant that there are a number of opportunities in the Japanese market that investors can position for. Some examples for consideration include:

  1. Large exporters and familiar names, such as Toyota, Sony, Nintendo, Uniqlo-parent Fast Retailing, etc.
  2. Semiconductor and chip stocks, such as Advantest, Tokyo Electron, Applied Materials, Screen Holdings, Keyence, Renasas, Lasertec, Arm-parent Softbank, etc.
  3. AI ecosystem such as software and data storage companies such as Fujitsu, NTT Data, CyberAgent, Hitachi, etc. or chemical companies like Shin-Etsu Chemical
  4. Warren Buffet holdings, that include Mitsui, Itochu, Sumitomo, Mitsubishi, Marubeni
  5. Machinery and automation manufacturers such as SMC, Fanuc, Komatsu, Mitsubishi Heavy Industries and other
  6. Renewable energy companies such as Kansai Electric, Tokyo Electric Power, Kyushu Electric, and others
  7. Demographics that could make healthcare, pharma and education sectors interesting
  8. ETFs such as iShares MSCI Japan ETF (EWJ), Global X MSCI SuperDividend Japan ETF (2564), iShares Currency Hedged MSCI Japan ETF (HEWJ) offer a broad exposure.

Understanding FX exposure

Foreign exchange (FX) risk is the potential volatility in the value of investments denominated in foreign currencies due to changes in exchange rates. For investors, FX exposure arises when they invest in assets denominated in a currency different from their own. Fluctuations in exchange rates can significantly impact investment returns, leading to gains or losses depending on the direction of the currency movements.

In the context of Japanese equity investments, FX exposure is particularly relevant for foreign investors holding assets denominated in Japanese yen (JPY). The exchange rate between the JPY and the investor's home currency determines the value of their Japanese equity holdings when converted back into their home currency. Therefore, changes in the JPY exchange rate directly affect the returns realized by foreign investors in Japanese equities.

The impact of FX exposure on Japanese equity investments is twofold. First, currency movements can amplify or dampen investment returns, potentially magnifying gains or losses for foreign investors. A weakening JPY, say against the USD, means US investors receive fewer dollars when converting the returns of their Japanese equity holdings, potentially offsetting the positive returns they made in Japanese equities. The chart below shows returns for Nikkei 225 in 2023 amounted to 28%, but JPY depreciation eroded the returns to 19% for a US-based investor. In some cases, if the yen weakness is significantly larger, then a foreign investor may still end up making a loss after converting their positive returns from Japanese stocks to base currency.

Secondly, the returns of Japanese equities are inversely correlated to JPY due to heavy export focus and safe-haven attributes of JPY. This means that JPY is generally expected to be on a weakening trend when Japanese equities perform strongly. As such, currency-hedged exposures can help mitigate this risk, allowing investors to focus on the underlying fundamentals of Japanese stocks without being exposed to currency fluctuations.

Hedging strategies

Forward Contracts

Forward contracts are agreements between two parties to exchange a specified amount of currency at a future date at an agreed-upon exchange rate. In the context of hedging FX risk, forward contracts allow investors to lock in a future exchange rate, thereby mitigating the uncertainty associated with currency fluctuations. For example, a US-based investor holding Japanese equities may enter into a forward contract to sell Japanese yen (JPY) and buy US dollars (USD) at a predetermined exchange rate in the future. By doing so, the investor can protect against potential losses resulting from a depreciation of the JPY against the USD or other base currencies.

Suppose USDJPY is at 150 now. An investor, with Japanese asset exposure, plans to convert yen back into USD in six months. They secure a six-month forward contract at an agreed rate of 150. After six months, if the exchange rate worsens to 170, meaning more yen per dollar, the investor can still convert at the forward contract rate of 150.

Options

Currency options provide investors with the right, but not the obligation, to buy (call option) or sell (put option) a specified amount of currency at a predetermined price (strike price) within a specified period (expiration date). Currency options offer flexibility and allow investors to limit downside risk while preserving upside potential. However, they typically involve upfront costs in the form of option premiums.

Consider an investor who wants to hedge against the risk of JPY depreciation, or a higher USDJPY. They will need to buy a call option on USDJPY to lock in the strike price at the current premium, and execute the call option in case the USDJPY rate is higher than strike price at the time of option expiry.

Currency or Currency-Hedged ETFs

Currency exchange-traded funds (ETFs) are investment funds that track the performance of a specific currency or a basket of currencies relative to another currency, such as the USD. For investors seeking a passive way to hedge FX exposure, currency ETFs offer an efficient and cost-effective solution. By investing in currency ETFs that reflect the performance of the JPY relative to the USD, investors can offset potential losses resulting from a weakening JPY. A bullish USD ETF could be useful to hedge risks of yen weakness. Meanwhile, currency-hedged versions of broad Japanese equities have also been popular. Key examples include iShares Currency Hedged MSCI Japan ETF (HEWJ) and WisdomTree Japan Hedged Equity ETF (DXJ).

Natural Hedges

Natural hedges involve leveraging existing business operations or investments to offset currency risk without the need for derivative instruments. One natural hedge strategy involves investing in Japanese companies with significant global operations. These companies may generate a substantial portion of their revenues and profits in foreign currencies, which can act as a natural hedge against currency risk. For example, a Japanese multinational corporation with operations in the US may benefit from a weakening JPY as it increases the value of its USD-denominated earnings when translated back into JPY. By diversifying across geographies and currencies, investors can reduce their exposure to currency risk and enhance portfolio resilience.


Is currency hedging costly?

One of the most common beliefs about currency hedging is that it’s costly. Although this may be a valid in some cases, it doesn’t hold true universally. The cost of hedging depends on the interest rate differentials between the base currency and currency of investment, along with market expectations for future exchange rate movements.

Currency hedging for a US investor with positions in Japanese equities can be relatively expensive due to wide interest rate differentials, but the cost of hedging can be offset by the carry trade opportunities available in the USDJPY currency pair.

In a carry trade, investors borrow funds in a low-interest-rate currency (the funding currency) and invest the proceeds in a higher-yielding currency (the target currency). The attractiveness of the carry trade is amplified when there is a positive interest rate differential between the two currencies. The interest rates in Japan have been lower than those in the US, making the USD a higher-yielding currency compared to the JPY. As a result, US investors can potentially earn a positive return from the interest rate differential, known as the carry, by funding their Japanese equity investments with US dollars.

In order to hedge currency exposure in Japanese equities, US investors could consider a long USDJPY position, that is buy USD and sell JPY. In this scenario, the trader is effectively borrowing JPY at the lower interest rates prevailing in Japan and investing in USD, which has higher interest rates compared to JPY. By holding the long USDJPY position, the trader earns the interest rate differential between the two currencies. If USDJPY goes up during the holding period, the return in Japanese equities are amplified by the long USDJPY position which yields both exchange rate upside and carry advantage. However, if USDJPY weakens, there is still a chance that carry returns could offset the movement in FX rates. However, the investor loses money on the FX hedge if the slide in USDJPY is large enough to offset the carry. But their returns from Japanese equities will be amplified due to the strength of the Japanese yen.

Overall, the carry trade opportunity in the USDJPY currency pair can make currency hedging relatively inexpensive for US investors with positions in Japanese equities, thereby allowing them to manage currency risk effectively while potentially enhancing their overall returns.

Other considerations for market participants

It is worth noting that currency hedging requires active monitoring and regular adjustment in portfolios. While long-term investors may decide to leave their allocations to global equities unhedged, investors more sensitive to short-term volatility may prefer some form of currency hedging.

A view on FX moves is also necessary to understand whether hedging would make sense or not. In the case of US investors looking to add exposure to Japanese equities, the expected move in USDJPY will be key to determine if hedging is needed or not. For instance:

  1. If investors expect yen to weaken over the holding period, one of the strategies mentioned above, including selling JPY forward or purchasing call options on USD/JPY, could be useful.
  2. If investors expect the yen to strengthen over their holding period, it might be worth taking on yen exposure and switch out of hedged share classes as yen gains will add to the equity gains.
  3. If yen is expected to stay sideways, it may still be worth looking at hedging given the positive carry of a long USDJPY position.

Ultimately, the decision to hedge or remain unhedged depends on investors' risk preferences, investment objectives, and market outlook.

Haftungsausschluss

Die Unternehmen der Saxo Bank Gruppe sind jeweils reine Ausführungsmakler und bieten Zugriff auf Analysen, über die Personen auf der oder über die Website verfügbare Inhalte ansehen und/oder nutzen können. Dieser Inhalt ist nicht dazu bestimmt, den reinen Ausführungsdienst zu ändern oder zu erweitern, und ändert oder erweitert ihn auch nicht. Der besagte Zugriff und die besagte Nutzung unterliegen jederzeit (i) den Nutzungsbedingungen, (ii) dem vollständigen Haftungsausschluss, (iii) der Risikowarnung, (iv) den Einsatzregeln und (v) den Hinweisen zu Saxo News & Research und/oder dessen Inhalten, zusätzlich (falls zutreffend) zu den Bedingungen für die Nutzung von Hyperlinks auf der Website als Mitglied der Saxo Bank Gruppe, über die der Zugriff auf Saxo News & Research erfolgt. Die besagten Inhalte dienen daher lediglich zu Informationszwecken. Insbesondere ist es von keinem Unternehmen der Saxo Bank Gruppe beabsichtigt, Beratung zu erbringen oder zu unterstützen oder dass sich Personen auf eine solche Beratung verlassen; ferner sind die Inhalte nicht als Aufforderung oder Anreiz für die Zeichnung oder den Verkauf oder Kauf irgendeines Finanzinstruments auszulegen. Sämtliche von Ihnen durchgeführten Handelstransaktionen oder Investitionen müssen auf Ihrer eigenen unaufgeforderten, fundierten und selbst bestimmten Entscheidung beruhen. Daher trägt kein Unternehmen der Saxo Bank Gruppe die Verluste und kann auch nicht für Verluste haftbar gemacht werden, die Ihnen infolge einer Anlageentscheidung entstehen, die Sie aufgrund von über Saxo News & Research verfügbaren Informationen treffen, oder für Verluste, die Ihnen infolge der Nutzung von Saxo News & Research entstehen. Erteilte Orders und ausgeführte Trades gelten als für das Konto des Kunden bei demjenigen Unternehmen der Saxo Bank Gruppe erteilt bzw. ausgeführt, das in der Jurisdiktion tätig ist, in der der Kunde wohnhaft ist und/oder bei dem der Kunde sein Handelskonto eingerichtet hat und führt. Saxo News & Research enthält keine von der Saxo Bank Gruppe angebotene, empfohlene oder unterstützte Finanzberatung, Anlageberatung, Steuerberatung oder Handelsberatung oder Beratung irgendeiner anderen Art (und es ist auch nichts so auszulegen, dass Saxo News & Research eine solche Beratung enthält); ferner ist Saxo News & Research nicht als Aufstellung unserer Tradingkosten oder als Angebot, Anreiz oder Aufforderung für die Zeichnung, den Verkauf oder Kauf irgendeines Finanzinstruments auszulegen. Soweit irgendein Inhalt als Anlage-Research ausgelegt wird, müssen Sie beachten und akzeptieren, dass dieser nicht in Übereinstimmung mit den rechtlichen Anforderungen zur Förderung der Unabhängigkeit von Anlage-Research erstellt wurde und dass er daher gemäss den einschlägigen Gesetzen als Marketingkommunikation angesehen werden würde.

Bitte lesen Sie unsere Haftungsausschlüsse:
Mitteilung zum unabhängigen Anlage-Research (https://www.home.saxo/legal/niird/notification)
Vollständiger Haftungsausschluss (https://www.home.saxo/legal/disclaimer/saxo-disclaimer)
Vollständiger Haftungsausschluss (https://www.home.saxo/legal/saxoselect-disclaimer/disclaimer)

Saxo Bank (Schweiz) AG
The Circle 38
CH-8058
Zürich-Flughafen
Schweiz

Saxo kontaktieren

Region auswählen

Schweiz
Schweiz

Wertschriftenhandel birgt Risiken. Die Verluste können die Einlagen auf Margin-Produkten übersteigen. Sie sollten verstehen wie unsere Produkte funktionieren und welche Risiken mit diesen einhergehen. Weiter sollten Sie abwägen, ob Sie es sich leisten können, ein hohes Risiko einzugehen, Ihr Geld zu verlieren. Um Ihnen das Verständnis der mit den entsprechenden Produkten verbundenen Risiken zu erleichtern, haben wir ein allgemeines Risikoaufklärungsdokument und eine Reihe von «Key Information Documents» (KIDs) zusammengestellt, in denen die mit jedem Produkt verbundenen Risiken und Chancen aufgeführt sind. Auf die KIDs kann über die Handelsplattform zugegriffen werden. Bitte beachten Sie, dass der vollständige Prospekt kostenlos über die Saxo Bank (Schweiz) AG oder den Emittenten bezogen werden kann.

Auf diese Website kann weltweit zugegriffen werden. Die Informationen auf der Website beziehen sich jedoch auf die Saxo Bank (Schweiz) AG. Alle Kunden werden direkt mit der Saxo Bank (Schweiz) AG zusammenarbeiten und alle Kundenvereinbarungen werden mit der Saxo Bank (Schweiz) AG geschlossen und somit schweizerischem Recht unterstellt.

Der Inhalt dieser Website stellt Marketingmaterial dar und wurde keiner Aufsichtsbehörde gemeldet oder übermittelt.

Sofern Sie mit der Saxo Bank (Schweiz) AG Kontakt aufnehmen oder diese Webseite besuchen, nehmen Sie zur Kenntnis und akzeptieren, dass sämtliche Daten, welche Sie über diese Webseite, per Telefon oder durch ein anderes Kommunikationsmittel (z.B. E-Mail) der Saxo Bank (Schweiz) AG übermitteln, erfasst bzw. aufgezeichnet werden können, an andere Gesellschaften der Saxo Bank Gruppe oder Dritte in der Schweiz oder im Ausland übertragen und von diesen oder der Saxo Bank (Schweiz) AG gespeichert oder anderweitig verarbeitet werden können. Sie befreien diesbezüglich die Saxo Bank (Schweiz) AG von ihren Verpflichtungen aus dem schweizerischen Bank- und Wertpapierhändlergeheimnis, und soweit gesetzlich zulässig, aus den Datenschutzgesetzen sowie anderen Gesetzen und Verpflichtungen zum Schutz der Privatsphäre. Die Saxo Bank (Schweiz) AG hat angemessene technische und organisatorische Vorkehrungen getroffen, um diese Daten vor der unbefugten Verarbeitung und Offenlegung zu schützen und einen angemessenen Schutz dieser Daten zu gewährleisten.

Apple, iPad und iPhone sind Marken von Apple Inc., eingetragen in den USA und anderen Ländern. App Store ist eine Dienstleistungsmarke von Apple Inc.