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Japan Hedged Equity Fund (DXL) Rises Amid Derivative Sale, Murky Outlook on Economy

Shares in the WisdomTree Japan Hedged Equity Fund ($DXJ) gained over 1.35 percent in early trading on Wednesday, following up a day when struggling Japanese equities pulled the WisdomTree Hedged

Shares in the WisdomTree Japan Hedged Equity Fund ($DXJ) gained over 1.35 percent in early trading on Wednesday, following up a day when struggling Japanese equities pulled the WisdomTree Hedged Equity Index lower. However, a Wednesday stock rally appeared to be pulling DXJ higher, as the Nikkei 225 has managed a 9.6 percent gain since its close on Friday. The Tokyo Stock Exchange was close on Monday, but DXJ fell 1.24 percent on Tuesday, moving against a modest 1.6 percent gain in the Nikkei.

The move for the DXJ comes during a year where derivatives trading surrounding the fund has picked up steam. It’s also moving amidst some potentially major shifts in the Japanese economy.

Barclays (BCS) Sells Notes on Fund

British investment bank Barclays (BCS) announced the sale of some $10.4 million in notes tied to DXJ on Wednesday. The notes, issued last Thursday, are three-year securities that will yield twice the fund’s gains with returns capped at 42.25 percent, protection against the first 20 percent of declines, and were given an initial value by the bank of 93.71 cents on the dollar.

The WisdomTree Japan Hedged Index tracks Japanese equities while hedging against fluctuations of value between the dollar and the Japanese yen, targeting traders and investors looking to separate Japanese equities plays from any Forex exposure. The index should magnify returns when compared to an unhedged index when the yen is weak against the dollar, while reducing them when the situation is reversed.

Investment banks have now sold $61.1 million in derivatives tied to DXJ since UBS AG (UBS) started selling them in April.

Japan’s Economy Set to Contract in Spring, Say Economists

The relatively murky outlook for the Japanese economy and how that could affect Japanese companies could be driving some of this derivatives activity.

The Japanese economy, which grew at an annualized rate of 3.8 percent in its second quarter despite initial estimates of just 2.6 percent, is set to take a hit come April of next year. That’s when an increase in the national sales tax that Prime Minister Shinzo Abe announced on October 1 will take effect, hiking the current rate of 5 percent to 8 percent. Abe also announced a $51 billion stimulus plan to coincide with the hike, hoping to reduce the nation’s debt burden without disrupting their anti-deflationary policies.

However, the outlook appears somewhat dim as economists polled by Bloomberg gave a median estimate of the Japanese economy will contract at an annualized rate of 4 percent for the quarter beginning in April.

New Governor of Bank of Japan (BOJ) Remains Optimistic

The new Governor of the Bank of Japan (BOJ), Haruhiko Kuroda,seemed to remain optimistic about a recovering economy despite any concerns over contraction due to the increased sales tax rate.

"Japan's economy is expected to grow above its potential as a trend, amid a continued virtuous cycle among production, income and spending, and is likely to steadily follow a path towards achieving a 2 percent price stability target," he noted during his first major policy speech as the Governor of the BOJ on Wednesday. "Since the turn of the year, real GDP has registered high growth of about 4 per cent on an annualized basis for two consecutive quarters [and] while exports have generally been picking up at a somewhat slower pace, domestic demand, notably private consumption and public investment, has been firm. Domestic demand is likely to maintain firmness as external demand is expected to increase the virtuous cycle among production and income, and spending is likely to be maintained.”

“Japan's real GDP growth in fiscal 2013 is now projected (at) 2.7 per cent, partly reflecting a front-loaded increase in demand prior to the consumption tax hike. What sets Japan's current economic recovery apart from past false dawns is that it is domestic demand-led, with the non-manufacturing sector as the main driver," he noted.

However, yesterday’s meeting of the BOJ’s monetary policy board, while echoing the positive sentiment, emphasized ample reason for concern regarding future growth.

"Japan's economy is expected to continue a moderate recovery. There remains a high degree of uncertainty concerning Japan's economy, including the prospects for the European debt problem, developments in the emerging and commodity-exporting economies, and the pace of recovery in the U.S. economy," said the meeting’s minutes.

Other Japan ETFs on the Move

Wednesday’s bump in the Nikkei helped boost other major Japanese equity ETFs. The iShares MSCI Japan Index Fund (EWJ) gained almost 1.25 percent, the MAXIS Nikkei 225 Index ETF (NKY) spiked over 1.5 percent, and the WisdomTree Japan SmallCap Dividend Fund ($DFJ) climbed almost 1.25 percent.

As the markets put the debt ceiling debacle in the rearview mirror, more than a few issues remain open.