Japan ETF Will Hedge Currency Risk

NEW YORK (TheStreet) -- On April 1, ETF investors will gain access to a new investment strategy for Japan when the WisdomTree Japan Total Dividend Fund (DXJ) begins hedging its yen exposure. This will allow foreign investors to invest in Japan as if they were domestic investors unconcerned about currency exchange rates.

At a time when the Securities and Exchange Commission is increasing its scrutiny of ETFs that use of derivatives out of concern that they amplify risk, the revamped WisdomTree offering reminds investors that derivatives can also be used to reduce risk.

When investors buy an ETF that holds stocks priced in domestic currency, they are taking on equity market risk. They benefit if the price of those assets increases and they lose if the price of those assets decreases. While there are many factors that go into determining whether those assets rise or fall in price, the direct risk is the price.

When investors buy an ETF that holds stocks priced in a foreign currency, they take on an additional risk. In addition to the equity risk, there is also the risk of the currency value rising or falling vs. the investor's home currency. This opens up four possible scenarios: both equities and the currency rise, both fall, or a combination of the two.

Today, this effect can be clearly seen in the European country ETFs that hold securities priced in euros. The iShares MSCI Germany Index Fund (EWG) tracks the MSCI Germany Index. The index is up 3.1% in 2010 when priced in euros, but it's down 3.3% when priced in dollars. EWG has done slightly better due to tracking error and is down 2.7%.

The major difference is caused by the currency losses in the euro -- CurrencyShares Euro (FXE) is down 5.9% thus far in 2010. Although a U.S. investor's holdings in German stocks have increased 3.1%, the value of the euro has declined so much that the total return is negative.

In the case of Japan, the iShares MSCI Japan (EWJ) is up 7.9% year to date, while CurrencyShares Japanese Yen (FXY) is up 0.6%. In the past month, however, FXY is down 3.9% and EWJ is up 5.7%. Priced in yen, the MSCI Japan Index gained 8.2% in the past month.

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