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A Well-Diversified Portfolio From One of the World's Largest Stock Markets

IShares MSCI Japan ETF is one of the best-diversified funds in the category, but performance has been lacking.

Daniel Sotiroff, 06/02/2017

IShares MSCI Japan ETF EWJ is one of the best diversified funds in the Japan stock Morningstar Category. Its market-cap-weighted approach to one of the world’s largest stock markets is worthy of a Morningstar Analyst Rating of Bronze.

This fund tracks the MSCI Japan Index, which is made up of large and midsize Japanese firms. MSCI’s methodology targets companies in the top 85% of Japan’s market capitalization. It also implements some buffering rules around this cutoff to reduce turnover.

The focus on Japan limits diversification, but many of the fund’s holdings are major multinational firms. Companies such as Toyota, Honda, and Sony are among the fund’s largest holdings and have global operations with diversified revenue streams. They also contribute to the fund’s heavier allocation to the consumer cyclical sector compared with broader international funds. This may cause Japan’s performance to differ from these broader portfolios.

Market-cap weighting places greater emphasis on the largest companies in Japan, which drives the fund’s risk/reward profile. Over the past five-, 10-, and 15-year periods the fund has underperformed the typical fund in its category. This was mainly a result of its emphasis on large and midsize companies, while many funds in the category focus on smaller Japanese firms. The fund currently has an average market cap of $20 billion, compared with the category average of $11 billion. However, it was less volatile than the category average over those same periods.

This fund does not hedge its currency exposure, so it does not provide protection from fluctuations in foreign exchange rates between the U.S. dollar and Japanese yen. This has been noticeable the past few years as the dollar has strengthened, and subsequently reduced the fund’s dollar-denominated returns. Over short periods, currency fluctuations may drive dollar-denominated returns higher or lower, but should largely wash out over long stretches of time.

Fundamental View
Japan’s stock market currently represents 18% of foreign-market capitalization, which makes it one of the largest developed markets outside of the U.S. As mentioned, major multinationals make up some of this fund’s largest holdings, including companies such as Toyota, Honda, and Sony. The Japanese market is also deep with other global firms such as Bridgestone, Komatsu, and Mazda further down the list of holdings. This fund holds stock in more than 300 companies and is well diversified with its top-10 holdings representing 20% of its assets. Companies are market-cap-weighted, which emphasizes the largest multinationals. This approach also keeps turnover low and mitigates transaction costs. However, it reduces the fund’s exposure to stocks as they become smaller and potentially priced to offer better returns going forward.

The fund has persistently underperformed the Japan stock Morningstar Category average, likely due to its larger market-cap orientation. Small companies have historically provided higher returns than those having larger market capitalizations. These firms also tend to be more highly leveraged to the fortunes of their domestic economies than their larger counterparts, and so may offer better diversification benefits to U.S. investors. However, they tend to have higher volatility, and the fund has been less volatile than the category average.

The Japanese economy has struggled to grow since the late 1980s. The Bank of Japan attempted to stimulate growth through quantitative easing programs in 2001, 2010, and 2012. The most recent attempt included lower interest rates, which promote borrowing and encourage investment. Quantitative easing caused the yen to decline against the U.S. dollar over the past few years, hurting the fund’s performance. The declining yen weighed on performance for U.S. investors over this period, as yen-denominated returns were almost 20% annually. While Japan is facing considerable challenges, including an aging population and large national debt, most of the fund’s holdings operate globally and gross domestic product has been climbing since late 2012. That said, they still appear to be struggling on the global stage. Both price/book ratios and return on invested capital are below those of broader international and global indexes.

This fund does not hedge against these moves in currency-exchange rates. Hedging out the effect of currency fluctuations may improve performance over specific periods when the dollar is strengthening relative to the yen. However, when the opposite occurs, hedging can work against investors and drive returns lower. Over long periods of time the impact of exchange-rate fluctuations is likely to be a wash, consistent with the historical pattern.

Portfolio Construction
This fund tracks the MSCI Japan Index and is composed of large and midsize Japanese companies. This transparent, well-diversified market-cap-weighted index accurately represents the Japanese stock market and exhibits low turnover, supporting a Positive Process Pillar rating.

MSCI sorts companies in the investable universe using their free-float-adjusted market capitalization. The index targets those firms that fall into the top 85%, with a buffer around that threshold to mitigate unnecessary turnover. The index is reconstituted semiannually in May and November. It makes smaller adjustments during additional quarterly reviews in February and August, such as adding recent IPOs. Additionally, stocks that are part of the index have liquidity requirements for remaining in the index. This helps keep bid-ask spreads low and contributes to lower transaction costs.

The day-to-day management of this index fund is mostly automated. The fund utilizes BlackRock’s Aladdin platform to automate currency hedging, cash management, and transactions. Trades are reviewed by the primary portfolio manager and audited by a second manager prior to execution.

This fund’s expense ratio of 0.48% is much lower than the 1.02% category average. It's priced similar to other Japan stock ETFs. However, it fails to distinguish itself, and therefore earns a Neutral Price Pillar rating.

The fund’s market-cap-weighted approach provides it with an advantage over its category peers. Turnover was last reported at 4%, which is lower than 94% of the funds in the category. The ETF structure also provides a considerable advantage on an after-tax basis. Its historic tax-cost ratio has been in the upper quartile of the category. The fund had not paid any capital gains distributions over the trailing 10 years through 2016.

WisdomTree Japan SmallCap Dividend ETF DFJ should offer cleaner exposure to the domestic Japanese market than EWJ. It weights small Japanese companies by annual dividends paid rather than market capitalization. This causes the fund to rebalance into stocks as they become cheaper relative to their dividends and away from those that become more expensive, giving the fund a value tilt. Its expense ratio is 0.58% and turnover tends to be higher.

IShares Currency Hedged MSCI Japan ETF HEWJ follows the same underlying MSCI Japan Index but attempts to hedge out the currency risk with currency-forward contracts. Its expense ratio is similar at 0.49% and has a Bronze rating.

Investors interested in additional diversification within the Pacific Rim region might consider Vanguard FTSE Pacific ETF VPL. Japan makes up 60% of this market-cap-weighted fund, but it has additional exposure to Australia, South Korea, Hong Kong, and Singapore. The expense ratio is low at 0.10%.

IShares Core MSCI EAFE ETF IEFA has a broader reach across foreign developed markets. It targets stocks across the entire market-cap spectrum of 21 developed market countries overseas. The fund is market-cap-weighted and Japanese firms account for 25% of its assets. This low cost fund (0.08% expense ratio) carries a Silver rating.

Daniel Sotiroff is an analyst, passive strategies research, for Morningstar Research Services LLC, a wholly owned subsidiary of Morningstar, Inc.

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