Japan, With a Hedge

Well-documented are Japan's economic woes. No longer the world's second-largest economy, the land of the rising sun is plagued by unfavorable demographics, soaring debt, tepid (at best) economic growth and anemic equity market returns.

China has wrested the crowns of Asia's largest economy (and the world's second-largest overall) from Japan, while a strengthening yen has punished Japanese equities for several years now. The rising yen has prompted a seemingly endless spate of bullish valuation calls on Japanese stocks. However, returns remain lackluster, implying investors would be well-suited to play Japan on a hedged basis.

"We believe Japan-based multinational companies that generate the bulk of their revenues from markets outside of Japan are more likely to benefit from a weakening yen," said WisdomTree Research Director Jeremy Schwartz in a note. "Companies with a purely Japanese revenue base, on the other hand, are unlikely to benefit from a weakening yen, especially if imported materials are part of their production process. Essentially, while a weakening currency can make exports more attractive for foreign consumers, it can also make imports less attractive, as these prices would tend to increase as the currency weakened."

The WisdomTree Japan Hedged Equity Fund (NYSE:DXJ), which has almost $516 million in assets under management, is one ETF investors can use to gain Japan exposure while hedging against dollar/yen fluctuations. Year-to-date, the WisdomTree Japan Hedged Equity Fund has outperformed the iShares MSCI Japan Index Fund (NYSE:EWJ). Both have trailed the the MAXIS Nikkei 225 Index ETF (NYSE:NKY).

DXJ has the potential to be even more alluring following an upcoming tweak by WisdomTree (NASDAQ:WETF) to the WisdomTree Japan Hedged Equity Index. At the close of trading on November 30, "the WisdomTree Japan Hedged Equity Index will be adding a geographic revenue filter to remove companies that derive the bulk of their revenue from Japan. As a result, the WisdomTree Japan Hedged Equity Index will allocate more weight and exposure to Japan-based multinational companies that we believe stand to benefit more from a weakening yen relative to the U.S. dollar," Schwartz said in the note.

Companies that derive more than 80 percent of their revenue from Japan will be excluded from the index. The ETF will also cap sector allocations at 25 percent. By employing the geographic revenue screen, DXJ's top-10 holdings could be dramatically altered, though WisdomTree noted that the ETF's new lineup will not be known until the screen is run on November 30.

Beyond the obvious lower dependence on Japan for the bulk of revenue, DXJ's new lineup could also sport a negative correlation to the yen over all relevant time periods, providing investors with the desired hedge effect.

"After the Japan revenue filter is applied, we believe the WisdomTree Japan Hedged Equity Index will become more exposed to sectors with revenues outside Japan," wrote Schwartz.

WisdomTree has previously employed a similar strategy in revamping established members of its product lineup. Earlier this year, the WisdomTree Europe Hedged Equity Fund (NYSE:HEDJ) was altered. In the process, HEDJ's exposure to risky European financial services firms was slashed while the fund's exposure to dividend-paying firms that derive more than 50 percent of their sales from outside of Europe was increased.

HEDJ has gained three percent since early September when the changes took effect.

For more on currency hedged ETFs, click here.