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.
As mentioned before, DXJ will continue to hold a portfolio of Japanese stocks, but starting April 1 the fund will offset the currency risk to Japanese yen by selling forward contracts. If DXJ had been using this strategy in the past month, it would have returned something closer to the MSCI Japan Index's 8.2% return, instead of 4.4%. Earlier this year, WisdomTree launched the WisdomTree International Hedged Equity Fund ( HEDJ). The portfolio is the same as WisdomTree DEFA Fund ( DWM) but comes with currency protection. DWM charges 0.48% in fees, while HEDJ charges 0.58%, an added cost of 0.1% for currency protection against multiple currencies. The cost to investors for this currency protection is nothing. For DXJ, there's only one currency to hedge, and the yen is one of the most widely traded currencies in the world. The new hedged ETF option increases the choices for investors. Let's look at four possible scenarios. When both a nation's currency and its stock market rise, investors can buy an unhedged foreign stock ETF and gain exposure to both. The updated DXJ, however, will be a bad choice in this scenario because the foreign investor will give up currency gains. When a nation's currency and its stock market fall, investors want to hold neither stocks nor currency. When a nation's currency falls but its stock market rises, investors previously might have chosen to stay out of that market, because the currency decline could overwhelm the rise in stocks. However, with DXJ, investors can benefit from a rise in Japan's stock market while avoiding losses from a decline in the yen. In the final scenario, a nation's currency rises but its stock market falls. In this case a fund like DXJ will suffer the largest losses, because it will be hurt by the currency change and by the declining value of the stocks. In such a case, investors will either want to stay out of the market or hold only the currency. Lastly, one interesting use for DXJ would be if Japan enters a period of hyperinflation. Japan's large debt burden, which has grown during a 20-year period when the economy has basically been stagnant, has some investors wondering whether serious inflation is in the country's future.
An extreme case of hyperinflation occurred recently in Zimbabwe. Investors buy all types of assets during hyperinflation to escape currency devaluation, including equities, which have some real value behind the shares. Zimbabwe was no different, and the country's stock market appreciated 322,111% in 2007, while the currency officially depreciated by about 12,000%. An American investor who put $10,000 in the Zimbabwe stock market at the start of the year would have seen his or her portfolio grow to $32 million, ignoring the currency depreciation. Once the currency was returned to dollars, the investor would be left with a still healthy $270,000. If the investor hedged his or her exposure, though, the return would have been the full $32 million. For those investors who worry about currency devaluation in Japan in the long run but expect Japanese stocks to rally, DXJ is the ETF to consider. -- Written by Don Dion in Williamstown, Mass. At the time of publication, Dion had no positions in stocks mentioned.