To hedge or not to hedge in Japan

Dramatic moves on Japan’s stockmarket and in its currency are driving investors and fund managers to consider the pros and cons of hedged and unhedged share classes 

Peter Brodnicki 480

Big moves in Japan’s stockmarket and currency have shifted investors focus towards Japan funds. For sterling investors, to be unhedged or hedged is an important decision, as currency can have a huge impact on returns.

Looking and comparing funds in the IMA Japan sector, it is clear it has been better to be hedged than unhedged over the last two years. In 2011, as the yen strengthened it was better to be unhedged. Weakening the yen is part of the plan to rescue the economy from deflation. The currency actually moves inversely to the stockmarket and so a weakening yen is good for Japanese equities too.

The yen depreciated against the dollar by about 6 per cent from the beginning of May to May 17, breaching the ¥100 mark. Such dramatic moves signal to investors that the best bet would definitely be to hedge out the currency exposure. However, are we likely to see such huge moves again?

The conundrum exists for the investor: is it better to be hedged or unhedged? One fund that can strategically hedge is the Neptune Japan Opportunities fund, where the manager Chris Taylor chooses to remove the hedge when he believes the yen will strengthen. In 2011, the FX hedge knocked 5.02 per cent off performance in 2011, but added 10.44 per cent in 2012.

Some funds in the Japan sector offer hedged or unhedged share classes. Bestinvest managing director of business development and communications Jason Hollands says while hedging the currency was the right move over the past year, the current conundrum is whether this is now fully priced in.

He adds: “It was a no-brainer and going long Japanese equities, short yen seven or eight months ago, but the easy money has probably been made from the currency play now. I’m personally in hedge share classes and do not see any need to change that.”

The Melchior Japan Advantage fund has sterling hedged and unhedged shares classes. Dalton Capital senior product manager Keizo Iguchi predicts the yen could depreciate modestly, going from levels of about ¥140 against the pound to ¥160 in two years time.

He says: “Japan is fully dependent on importation of oil and so if the yen depreciates to 110 or 120 against the dollar, it will be more expensive to import, which is not good for the economy.”

He adds: “As I expect the yen to depreciate against other currencies, then in order to avoid currency losses, hedged is better than being unhedged over the next two years.”

Old Mutual run a range of unhedged and hedged share classes on Japan funds. The Old Mutual Japan Equity fund is unhedged. Manager Ian Heslop , who runs this fund, cautions that dramatic moves in the yen over the last two years may not be seen again in the next two years, as it is not usual to see big moves in currency every year.

Supporting this view, he says such dramatic moves could upset Japan’s trading partners. Heslop says: “The G20 in April did not actually say that Japan was manipulating its currency, but it was not far off. “

TM Darwin founder David Jane agrees there is unlikely to be a dramatic move in the yen again. He has been selling his exporters exposure that are a play on the weak yen and invested more in defensive plays in domestic names. The TM Darwin Multi-Asset fund has shifted from two thirds in exporters and one third in domestics companies in March to 70 per cent in domestics and 30 cent in exporters now.

He says: “ I think we have seen the big move in the yen now and it may settle here for some time. The domestic companies play into the basic thesis that Japan has an economy that can recover and the market is cheap.”

Jane was 80 per cent hedged in the portfolio at the beginning of the year. “We only hedge half the portfolio now because our view on a weakening yen is not strong enough. As the yen goes down, the stockmarket goes up and so by hedging, you are actually increasing your volatility.”

JO Hambro Capital Management, which has a hedged and unhedged version of the JOHCM Japan fund, agree that dramatic depreciation in the yen is not expected. Manager of the fund, Ruth Nash, says: “We expect the yen to weaken modestly from here, as once you get much above ¥100 to the dollar, you start to see some of the US companies raising objections to the US government about Japan having a competitive advantage.”

She adds that as they expect only modest depreciation, it will not make a large amount of difference as to whether you are hedged or unhedged from this perspective.

Hargreaves Lansdown senior investment manager Adrian Lowcock says: “Over threeyears hedging the currency on the Topix would have given you an extra 12 per cent, however it does come with added volatility around 40 per cent more.”

Lowcock sees the case for hedging but only in the short-term. He says: “As the currency weakens, the stockmarket usually rises. So to profit initially you need to hedge the currency out if you are looking at it from a shorter term timeframe of one or two years.”

Lowcock adds: “However, the currency won’t fall forever (at least that is not the aim). Over the longer-term, the yen can only fall so far and if unhedged, investors get direct exposure to the market returns and they do not pay for the hedge.”