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Investing in Japanese Equity? Mind the Forex

VIDEO: 'Abenomics' has helped fuel a surge in Japanese equities, but investors wanting to join in on the action need to hedge against yen depriciation

Holly Cook 1 May, 2013 | 6:00AM

Holly Cook: Japanese equities have had a stellar start to the year so far. I’m joined today by Jose Garcia Zarate, he is a senior analyst on our passive funds research team, and we’re going to talk about some of the things investors need to be aware of when investing in this region. Jose, thanks very much for joining me.

Jose Garcia Zarate: Thanks for inviting me.

Cook: So can you explain a little for us, what is the economic background that’s fuelling this rise in Japanese equities?

Zarate: Well, basically, Japan for the best part of the last two decades has been in bit of a rut in terms of economic performance. The arrival of a new government last year, and the arrival of a new governor in the Bank of Japan quite recently, has created a bit of a revolution. They’re going to try to reflate the economy by a combination of very fiscal – very aggressive fiscal policy and also very aggressive monetary policy, and that’s creating a lot of expectations that Japan is going to be able to come out of its torpor and perform much better into the future. Obviously, that has a clear sort of like translation into the performance of the stock market in Japan, which has increased by at least 30% so far in the year. So, you see, it’s quite substantial.

Cook: So this recent sort of hype around Japanese equities is also happening at the same time as yen depreciation. So what’s happening there?

Zarate: Well, yen depreciation is actually one of the key objectives of this so-called “Abenomics”. Shinzo Abe is the name of the Prime Minister and they decided to call this new strategy, policy strategy, Abenomics. Basically, going back to the yen, one of the key issues and key problems that the Japanese economy have been facing for the past 20 years has been deflation. What they’re trying to do is to reflate the economy, i.e. to create inflation and to promote investment into sort of risky assets and promote actually consumption, private consumption of the Japanese domestic demand. When you try to create inflation, obviously, this has a direct implication on the currency markets. The currency, obviously, is going down and that’s basically what’s happened. The yen has come down versus most of the developed currencies around the world.

Cook: So if I’m an investor and I believe that Abenomics is going to be successful, it’s going to continue to fuel Japanese equities and investment and I want to get in on the action, what do I need to be aware of in terms of the yen depreciation as well?

Zarate: Well, if you are investing in any sort of non-domestic currency denominated asset class, you need to take into consideration two factors. One is the performance of the asset class that you’re going into, in this case that would be the equity, the Japanese equity market; and the other factor, very important, is always the foreign exchange factor. So, for example, as I mentioned earlier, the Japanese equity market has gone up by about 30% so far in this year. But that could be very easily cancelled out by the depreciation of the yen, which has been around 20% against the US dollar. So a comprehensive strategy would need to take into consideration a hedge for foreign exchange depreciation. Now, you can do that separately from your main sort of investment in the equity market; for example, you can use options or currency futures. But not very many people actually have the ability or understand how to operate those markets. Or you can actually go the easy way and actually buy a product that has an inbuilt foreign exchange hedge. There are some ETFs that offer that possibility.

Actually, I’m just thinking, if you’re a sterling investor, a UK investor, obviously sterling hasn’t been doing particularly well either against some of the major currencies. So where you would be actually [investing] if you got an ETF that offers you exposure to the Japanese equity market but also hedges, let’s say, in US dollars, is indirectly you would be actually killing two birds with one stone, so to speak, because you would be actually accounting for some of the depreciation of sterling against the dollar as well. So there are various ways that you can profit. But the most important thing is to hedge against the yen, and not just go into the Japanese equity market on a plain vanilla non-protected basis.

Cook: So a little bit more research needed perhaps on behalf of the investor, but as long as you’re aware of that forex risk, it’s still an interesting area to look at.

Zarate: If you think the equity market is going to continue performing, then you should be aware that the side-effect of this new economic policy in Japan is going to be that the yen is going to go down, and that can dent any sort of upside on the equity performance for a non-Japanese investor.

Cook: Well, it’s time for me to say sayonara. Thank you very much for joining me, Jose.

Zarate: Arigato.

Cook: If you want more information on ETFs that offer exposure to Japanese equities, see the link below this video. For Morningstar, I’m Holly Cook. Thanks for watching.

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The information contained within is for educational and informational purposes ONLY. It is not intended nor should it be considered an invitation or inducement to buy or sell a security or securities noted within nor should it be viewed as a communication intended to persuade or incite you to buy or sell security or securities noted within. Any commentary provided is the opinion of the author and should not be considered a personalised recommendation. The information contained within should not be a person's sole basis for making an investment decision. Please contact your financial professional before making an investment decision.

About Author Holly Cook

Holly Cook  is Managing Editor of Morningstar.co.uk