Credit Suisse analyst Victor Lin says in his April 17, 2014 research note that the traditional spread dynamics between the WisdomTree Japan Hedged Equity Fund (NYSEARCA:DXJ) and iShares MSCI Hong Kong Index Fund (ETF) (NYSEARCA:EWH) are likely to normalize in the near future.

The spread between the two funds shot up to an abnormal level recently weeks as can be seen in the chart below.

ETF Spread DXJ

Note how the ETF spread exceeded (-) 1.5 standard deviations recently for the first time since July 2013 when it had shot beyond (+) 1.5 standard deviations (shown in the chart on the right in red highlights).

“In our monitoring of liquid ETF pairs that have shown a mean-reverting (cointegrated) relationship over the past year, WisdomTree Japan Hedged Equity Fund (NYSEARCA:DXJ) and iShares MSCI Hong Kong Index Fund (ETF) (NYSEARCA:EWH) stood out as one pair that had significantly diverged in the past few weeks,” noted Lin. “Recently, the spread between the two has started to tighten, suggesting the statistical relationship between the pair could be heading back to its near-term average.”

About the funds

The WisdomTree Japan Hedged Equity Fund (NYSEARCA:DXJ) is an outstandingly successful ETF launched by WisdomTree Investments, Inc. (NASDAQ:WETF). Focused on Japanese dividend paying companies, the fund is based on the WisdomTree Japan Dividend Index and is currency-neutral because it hedges out the exposure to the US Dollar/Japanese yen pair. The fund’s hedged status enabled it to post superior returns compared to other Japan-oriented ETFs which lost heavily on their currency exposure due to the Abenomics-induced depreciation in the yen. As a result, the fund has been able to garner over $11 billion in assets under management.

The iShares MSCI Hong Kong Index Fund (ETF) (NYSEARCA:EWH) ETF tracks Hong Kong stocks measured by the MSCI Hong Kong Index.

ETF spread: Trading strategy

The idea behind the Credit Suisse strategy is to go long DXJ and short on EWH in the ratio (1:2.4) with the objective to profit from a narrowing of the current ETF spread towards its historical average.

Risk: Reward

“If the spread reverts to its one year mean, the pair would return 6.9%. More conservatively, if it returned to its 2 month average spread, the pair would return 5.4%,” says analyst Lin.

Risk could arise from a fundamental change in the Japanese and Hong Kong markets that makes the ETF divergence a more permanent feature than the statistical record hitherto – in such a case the reversion of the spread to its historical average would not materialize and the trade would fail.

Current status of the ETF spread

It can be observed that between the date of the Credit Suisse report and Friday’s close, there is indeed a narrowing of spreads between WisdomTree Japan Hedged Equity Fund (NYSEARCA:DXJ) and iShares MSCI Hong Kong Index Fund (ETF) (NYSEARCA:EWH), as shown in the chart below:

Spread DXJ EWH

The longer blue bar represents the spread prevailing around the time of the report, while the second bar shows the current spread about a week later.

It therefore appears that the strategy is still functioning as envisaged.