Bull vs. Bear: Is The Hype for Japan ETFs Justified?

Bull vs. Bear is a weekly feature where the VettaFi writers’ room takes opposite sides for a debate on controversial stocks, strategies, or market ideas — with plenty of discussion of ETF ideas to play at either angle. For this edition of Bull vs. Bear, Nick Peters-Golden and Karrie Gordon discussed the fundamentals for and against investing in Japan ETFs.

Nick Peters-Golden, staff writer, VettaFi: Hi Karrie! I’ve been looking forward to this one for a while because, with the debt ceiling, rising rates, and a looming recession, U.S. equities are stressful enough. Investing in Japan ETFs doesn’t just offer diversification; it also presents one of the strongest opportunities for portfolio returns worldwide right now.

Karrie Gordon, staff writer, VettaFi: As an anime fan since my teenage years, I’m a big fan of Japan and much of its culture. When it comes to investing, however, I’m happier to sit on the sidelines, at least for now. There’s a lot of uncertainty currently regarding the direction of the Japanese economy and monetary policy. In a second half rife with risk, Japan’s outlook is just too nebulous for ETF investors, in my opinion.

Weakening Yen Spells Opportunity for Currency Plays

Peters-Golden: Let’s start with perhaps the strongest point in favor of investing in Japan ETFs right now: currency hedging. Specifically, the carry effect. The carry effect between Japan and the U.S. is more attractive than any other developed market pairing. The difference between interest rates in two currencies helps calculate the “cost of carry” for those currencies.

We can see the effect of the cost of carry in a pair of examples, thanks to the analysts over at WisdomTree Investments. In their example, when foreign interest rates rise higher than U.S. interest rates, like in Brazil, hedging currency exposure costs investors. In the inverse scenario, with, say, Japan, the carry effect pays investors to hedge currencies.

The formula accounts for the difference in rates, and with the Federal Funds Rate around 5% as of May, and Japan’s rate at -0.03%, that gap pays. Effectively, the carry effect paid investors 5.4% trading dollar-yen currency pair futures as of mid-May. The Fed’s rate hikes have taken rates so high so quickly, and likely for a long while, that Japan currency hedging looks to be a really promising opportunity.