Tempted by Japan’s booming market? Be like Warren Buffett

Warren Buffett once said he focused only on things that are important and knowable. Currency fluctuations aren’t one of them—they might be important, but they aren’t knowable.

He has made a killing recently investing in Japan, and investors who followed his lead have too—a lesson in diversification. Japanese stocks have been booming: In the past five years, the MSCI Japan Index, measured in yen, has gained 87%, beating even the mighty S&P 500.

Yet if U.S. investors had just jumped into the largest Japan-focused exchange-traded fund, they would have made much less. The iShares MSCI Japan ETF has generated only a 36% total return in the past five years as the yen has lost a third of its value against the dollar over the period.

For Buffett, who first disclosed his Japanese investments in August 2020, his currency risks have been hedged by borrowing in yen at low rates. Most recently, Berkshire Hathaway, Buffett’s investment flagship, issued the equivalent of $1.6 billion of yen-denominated bonds in April, with interest rates ranging from 0.97% to 2.5%. Share prices of the five Japanese trading houses that Berkshire owns have nearly quadrupled on average since August 2020. They have risen only 150% in dollar terms—still respectable, but substantially less.

Of course, currency moves don’t occur in a vacuum—they can be good or bad for an export juggernaut such as Japan. But the conventional wisdom that a weaker yen helps Japanese stocks has also broken down lately. The Topix index rose only 1.5% last quarter, even though the yen depreciated 6% against the dollar to the weakest in more than three decades. Even shares of exporters such as Toyota, which should benefit from a weaker yen, fell last quarter. The rapid decline in the yen could reignite inflation, hurting growth in real wages and consumption. It also could force the Bank of Japan to raise interest rates sooner than it might have otherwise.

Like so much else for investors, the yen’s near-term future hinges on the Federal Reserve. The interest-rate gap between the U.S. and Japan has been a significant factor pushing it lower. While Japan has started raising interest rates slowly, slower-than-expected rate cuts across the Pacific have sunk the hopes of a stronger yen.

Individual investors can’t copy Buffett by borrowing in Japanese yen, but they can let the ETFs do the hedging for them. The currency-hedged Japanese ETF from iShares has gained 31% in the past year compared with 12% for the unhedged version.

The factors that attracted savvy foreigners such as Buffett—improving corporate governance and shareholder returns—could continue to act as a tailwind for Japanese stocks. Just don’t neglect the other side of his trade—not betting on what isn’t knowable, even to him.

Write to Jacky Wong at jacky.wong@wsj.com