Diversifying With the Yen? Not If Japanese Equities Are Involved

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 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