Diversifying With the Yen? Not If Japanese Equities Are Involved

Diversifying With the Yen? Not If Japanese Equities Are Involved by Jeremy Schwartz, WisdomTree

As a leading sponsor of currency-hedged exchange-traded funds, we engage in a fair amount of discussion regarding the “currency bet,” that is, the added risk investors layer on top of equity returns when they invest internationally. One reason often cited is that it helps diversify exposure to the U.S. equity markets (defined here as the S&P 500 Index).

The Japanese yen, for example, looks like an interesting asset class to achieve this, as the yen has displayed a negative correlation to the S&P 500 (INDEXSP:.INX) over the last 40 years, with a sharper negative correlation in more recent years.

However, there are two sides to the coin. While the yen correlates negatively to U.S. equities, it is also negatively correlated to the Japanese equity market (as measured by the MSCI Japan Index). In fact, the negative correlation in Japan is even higher than that of the U.S., which means that Japanese stocks will take a significant hit in a rising yen environment.

Consider that the three-year correlation of the S&P 500 and the yen was -0.33, but the three-year correlation of the yen and the MSCI Japan Index (in yen) was -0.74. If investors wanted a hedge for a bearish scenario in the U.S. equity markets, the historical correlation data would suggest the yen could serve that choice as a standalone investment, but not if not packaged with Japanese equities.

Figure 1: Three-Year Correlation of Yen vs. S&P 500 Index

Figure 2: Three-Year Correlation of Yen vs. MSCI Japan Index

Figure 3: MSCI Japan Index: Return, Volatility and Correlation Table

Diversification vs. Risk

The discussion of currency-hedged strategies has shaken some of the core beliefs of investors. Traditional investment vehicles that package equity risk plus a secondary currency risk on top of the equity risk have been referred to as the traditional “plain vanilla” exposure because they were the first to the market, and it is what investors have been using for so long.

The yen is a currency that looks like a portfolio diversifier, as it has a negative correlation to U.S. equities. But when the yen is packaged on top of Japanese equities, which have an even stronger negative correlation to the yen, that diversification benefit is compromised and ultimately becomes nothing more than added risk.

Japan was a market that highlighted the benefits of a currency-hedged approach in 2013 as the yen sank and stocks performed very well¹. Increasingly, investors will come to look at currency-hedged products as more strategic options for international allocations, as they continue to question the diversification benefit of layering currency risk on top of international equities.

¹Source: Bloomberg, 12/31/12–12/31/13; references the yen weakening more than 17% against the U.S. dollar while the MSCI Japan Local Index was up more than 54%. Past performance is not indicative of future results.