The Yen ETF: A Screaming Buy for Long-Term Investors

Importance of Yen ETF in the financial market:

Updated July 31. 2024

Introduction

In recent years, the Japanese Yen ETF has emerged as an essential financial instrument, offering investors a convenient and cost-effective way to gain exposure to the Japanese currency. As the world’s third-largest economy, Japan’s economic trends and monetary policy decisions can significantly impact global markets. Yen ETFs allow investors to profit from these dynamics without the complexities of directly trading currencies.

However, investing in Yen ETFs is not without risks. The yen has experienced significant volatility in recent years, influenced by factors such as diverging monetary policies between the U.S. and Japan, geopolitical tensions, and shifting economic fundamentals. In 2023, Japanese authorities faced pressure to combat the yen’s sustained depreciation as it slid to a one-year low against the dollar.

As legendary trader Jesse Livermore once said, “There is only one side to the stock market, and it is not the bull or bear sides, but the right side.” Successful investing in Yen ETFs requires a deep understanding of the underlying currency dynamics, the ETF’s structure and risks, and the ability to capitalize on mispricings and opportunities as they arise.

What are Yen ETFs?

Yen ETFs are investment funds that track the performance of the Japanese yen relative to other currencies. They expose the yen by investing in yen-denominated assets like Japanese stocks, bonds, and currency futures. Yen ETFs allow investors to profit from the yen’s movements without directly trading currencies.

How Yen ETFs Work

– Yen ETFs buy a portfolio of yen-denominated assets to mirror yen returns
– The ETF’s value depends on the performance of the underlying yen assets
– Yen ETFs charge management fees which reduce investor returns
– They trade on exchanges like stocks, providing liquidity and convenience

As Warren Buffett says, “Price is what you pay, value is what you get.” Investors must weigh the fees and costs of Yen ETFs against the value and diversification they provide.

Buffett’s Yen Investments

Warren Buffett has made significant moves in Japan, demonstrating his keen eye for value and strategic currency plays:

– In 2020, Berkshire Hathaway disclosed $6 billion stakes in five Japanese trading houses
– Buffett cleverly issued yen-denominated bonds to fund these purchases, capitalizing on Japan’s ultra-low interest rates
– By the end of 2023, Berkshire had made unrealized gains of over $8 billion on these investments

Buffett’s strategy involves a unique currency hedge: the trading houses earn profits in dollars while the debt is in yen. This approach showcases how to leverage undervalued assets and favourable currency dynamics.

Buffett’s long-time partner, Charlie Munger, described this opportunity as “straightforward money” and compared it to a “gift from God” due to the minimal risk and attractive returns.

Buffett’s fascination with Japanese stocks continues. In 2024, Berkshire priced 263.3 billion Japanese yen of bonds worth $1.7 billion, one of its most significant yen bond sales. This move has sparked speculation that Buffett might want to expand his investments in Japan.

Jesse Livermore’s wisdom rings true here: “There is only one side to the stock market, not the bull or bear sides, but the right side.” Buffett’s Japan plays demonstrate the importance of being on the right side of a trade, combining value investing principles with savvy currency management.

These investments highlight how focusing on value and patiently waiting for the right opportunities can lead to substantial returns, even in markets that others might overlook.

Diversification and Hedging with Yen ETFs

Yen ETFs offer a powerful tool for portfolio diversification and currency risk hedging, particularly for investors heavily weighted in U.S. dollar assets. As central banks increasingly diversify away from U.S. dollars and Treasuries, individual investors can follow suit using Yen ETFs.

Key Benefits:
– Currency Diversification: Reduces dependence on the U.S. dollar
– Hedging: Protects against currency risk for investors holding Japanese stocks or bonds
– Potential Returns: Can generate substantial gains if the yen appreciates against major currencies

Popular Yen ETF Options

1. Invesco CurrencyShares Japanese Yen Trust (FXY): A physically-backed yen ETF
2. ProShares Ultra Yen ETF (YCL): Offers 2x long exposure
3. ProShares UltraShort Yen ETF (YCS): Provides 2x inverse exposure

Strategic Portfolio Integration

Experts suggest various approaches to incorporate Yen ETFs:

1. Intermediate Approach: Use about 8 ETFs, including core bonds, international bonds, U.S. large-cap and small-cap, emerging markets, and a Yen ETF.
2. Simplified Strategy: Combine an all-country stock index ETF (e.g., MSCI ACWI) with a bond ETF and a Yen ETF, allocated based on risk tolerance.
3. Comprehensive Diversification: Add Yen ETFs to a mix of stocks, bonds, commodities, and real estate ETFs.

The Lemming Effect and Bandwagon Effect

While Yen ETFs offer diversification benefits, investors must be wary of the lemming effect and bandwagon effect:

1. Lemming Effect: This occurs when investors blindly follow others’ investment decisions without proper due diligence. For example, during the Japanese asset price bubble of the late 1980s, many investors piled into Japanese assets, leading to unsustainable valuations.

2. Bandwagon Effect: This is the tendency for people to adopt certain behaviours or beliefs because many others are doing so. In the context of Yen ETFs, a sudden surge in popularity could lead to overvaluation if investors jump on the bandwagon without considering fundamental factors.

To avoid these pitfalls:
– Conduct thorough due diligence
– Adopt a contrarian mindset when appropriate
– Stick to a well-defined investment plan aligned with your goals
– Regularly rebalance your portfolio to maintain desired allocations

Risks and Considerations

While Yen ETFs offer diversification benefits, it’s crucial to understand the risks:

– Yen volatility influenced by economic trends, monetary policy, and geopolitical events
– Potential for over-concentration if not balanced with other assets
– Currency hedging costs can impact returns

Yen ETFs provide a liquid, transparent, cost-effective way to diversify with yen exposure. By thoughtfully incorporating them into a well-constructed portfolio, investors can potentially enhance returns and manage risk. However, as with any investment, thorough due diligence and understanding the risks are essential to avoid falling victim to lemming-like behaviour or jumping on unsustainable bandwagons.

List of Yen ETFs

A comprehensive List

iShares Currency Hedged MSCI Japan ETF (HEWJ)

WisdomTree Japan Hedged Equity Fund (DXJ)

ProShares Ultra Yen ETF (YCL)

Invesco CurrencyShares Japanese Yen Trust (FXY)

Deutsche X-trackers MSCI Japan Hedged Equity ETF (DBJP)

iPath JPY/USD Exchange Rate ETN (JYN)

ProShares Short Yen ETF (YCS)

WisdomTree Japan SmallCap Dividend Fund (DFJ)

iShares MSCI Japan ETF (EWJ)

First Trust Japan AlphaDEX Fund (FJP)

Historical Performance

Yen ETFs have delivered mixed results historically. The WisdomTree Bloomberg Japanese Yen Bullish Fund (JYN) has returned -0.27% annually since its 2006 inception, while the Invesco CurrencyShares Japanese Yen Trust (FXY) has returned -2.47% annually since 2007. However, the yen’s safe-haven status has yielded solid returns during market turmoil. In 2008, FXY gained 23.5% as investors fled to safety during the financial crisis.

Current Trends
The yen has been trading at multi-year lows against the U.S. dollar, with the USD/JPY exchange rate reaching 134 in 2023, its highest level since 2002. The weakness is attributed to the Bank of Japan’s ultra-loose monetary policy diverging from the Federal Reserve’s tightening cycle. However, some experts see an opportunity in the yen’s undervaluation. Lyn Alden, a renowned macro strategist, notes that the yen is “the most undervalued currency in the world” based on purchasing power parity.

Contrarian Opportunity
From a contrarian perspective, the yen’s oversold condition may present a compelling long-term investment case. Ray Dalio, founder of Bridgewater Associates, has highlighted the potential for a global “paradigm shift” where the U.S. dollar loses its reserve currency status. In such a scenario, the yen could appreciate significantly as a safe-haven alternative. Dalio suggests that “the yen is attractive” as part of a diversified portfolio.

Future Outlook

The future outlook for Yen ETFs is mixed. While the yen’s undervaluation and potential safe-haven demand provide a bullish case, Japan’s demographic challenges and low-growth environment may limit upside potential. However, a shift in the Bank of Japan’s monetary policy or a weakening U.S. dollar could catalyse yen appreciation. As with any investment, thorough due diligence and a long-term perspective are essential.

Conclusion

Yen ETFs offer a unique way to diversify portfolios and potentially capitalize on the yen’s fluctuations. Recent data shows that the yen has been under pressure, reaching a 34-year low against the U.S. dollar in early 2024. This situation presents both risks and opportunities for investors considering Yen ETFs.

The yen’s status as a safe-haven currency and Japan’s position as a significant creditor nation still provide a compelling long-term investment case. During global uncertainty, the yen often appreciates as investors seek safety. For instance, during the initial shock of the COVID-19 pandemic in early 2020, the Invesco CurrencyShares Japanese Yen Trust (FXY) saw a notable uptick.

Recent developments in Japan’s monetary policy add another layer of intrigue. In April 2024, the Bank of Japan (BOJ) raised interest rates for the first time in 17 years, ending its hostile interest rate policy. This shift could potentially strengthen the yen and impact Yen ETF performance.

However, investors must carefully consider the risks. Japan’s ageing population, high government debt, and ongoing economic challenges remain concerns. While rising, the country’s inflation rate still lags behind other major economies, which could influence currency dynamics.

Yen ETFs should be considered a tactical allocation within a diversified portfolio rather than a core holding. They can serve as a hedge against dollar weakness or as part of a broader currency diversification strategy.

As Ray Dalio, founder of Bridgewater Associates, often emphasizes, “Diversifying well is the most important thing you need to do to invest well.” Yen ETFs can play a role in this diversification, but investors should thoroughly understand the underlying currency dynamics, ETF structures, and potential risks and rewards before investing.

The current global economic landscape, characterized by shifting monetary policies, geopolitical tensions, and varying recovery rates from the pandemic, underscores the importance of a well-researched, balanced approach to currency investments. By staying informed about these factors and their potential impacts on the yen, investors can make more educated decisions about incorporating Yen ETFs into their investment strategies.

In conclusion, while Yen ETFs offer unique opportunities, they require careful consideration within the context of an investor’s overall portfolio strategy and risk tolerance. As always, thorough research and a clear understanding of one’s investment goals are paramount in investing.