Strong Buying in Japan ETFs Drives Premium to NAV

On Tuesday March 15, Japanese ETFs began trading at a 4% to 5% premiums to their net asset values, due to strong buying in the market. While the less liquid international ETFs are more likely to trade at a premium or discount, iShares MSCI Japan Index EWJ is one of the most heavily traded international ETFs and is on track to trade at 20 times its three-month average daily trading volume of 23 million shares. Because the Japan market is closed during our trading day, the price of Japan ETFs listed in New York can veer away from its NAV value (which is based on the prices of Japan stocks which are not trading) on market moving news. In this case, there is no positive news, but it is likely that optimistic investors are looking back to the 1995 Kobe earthquake to see that while Japan's blue chip Nikkei index sold off immediately after the earthquake, the markets and the economy recovered relatively quickly. (The Nikkei continued to tumble in the first half of 1995 but ended the year slightly up, while GDP in Japan rose 3.4% in the first quarter of 1995.) Other developed countries that have experienced disasters have also recovered quickly, thanks to an educated population, solid infrastructure, and resources to support rebuilding efforts. In our opinion, in the near term, the risk continues to be on the downside given the uncertainty regarding the damaged nuclear power plants' effect on nearby residents, and Japan's power infrastructure and manufacturing sectors.

However, in the medium term, a potential positive outcome of this terrible disaster would be a more focused federal government, which could more effectively steer Japan's economy. During the past five years, Japan has had five prime ministers and currently has a fragmented parliament. The government has been unable to pass budget bills, nor tamp down the appreciation of the yen, which is driven by Japan's current account surplus. The yen is currently sitting near five-year highs against the U.S. dollar, despite rock-bottom interest rates and Japan's economic underperformance, relative to developed-markets peers.PAGEBREAK

A weak economy, a lack of leadership, and an appreciating yen continue to weigh on the performance of large-cap Japanese companies, many of which are major exporters. In a strong yen environment, Japanese exports are more expensive, which can hurt the sales and profitability of Japan's large cap auto, technology industrial, and other large export-oriented firms. However, while the performance of Japanese equities has been weak, U.S.-based investors in Japan have benefited from the rising yen. In 2010, the MSCI Japan Index, in yen, was up 0.7%, while, in U.S. dollars, was up 15.6%. Annualized over three years through Dec. 31, 2010, the index, in yen, was down 14.1%, compared with down 4.5% in U.S. dollars.

On Monday March 14, 2011, the yen continued to strengthen on the expectation that Japanese companies would repatriate overseas profits to fund reconstruction efforts at home, which would drive up demand and the value of the yen. The Bank of Japan moved quickly to double the size of its asset purchase program to $122 billion, as well as inject $184 billion into the financial system to boost liquidity, and these efforts helped stem the rise in the yen.

Over the coming months, we think the Japanese government will be more determined in managing the yen's exchange rate, which would be beneficial for Japan's large-cap exporters. At this time, Japanese exporters stand to benefit from a recovering U.S. economy and healthy near- and medium-term growth from China, now its largest trading export market after the U.S. For investors who have unhedged exposure to Japan equities (most ETFs invested in Japan equities are not hedged) we suggest considering a fund like WisdomTree Japan Hedged Equity DXJ, which hedges its yen exposure. In a falling-yen environment, this ETF would outperform a nonhedged, broad market Japan equities fund, whose returns would be negatively affected by the weakening currency. We advise investors looking to trade Japan ETFs in the coming days to carefully monitor the fund's intraday NAV (on Morningstar.com, use the ticker DXJ.IV to see the intraday indicative value), as these funds are trading at significant premiums.

Patricia Oey is an ETF analyst with Morningstar.

Disclosure: Morningstar licenses its indexes to certain ETF and ETN providers, including Barclays Global Investors (BGI), Claymore Securities, First Trust, and ELEMENTS, for use in exchange-traded funds and notes. These ETFs and ETNs are not sponsored, issued, or sold by Morningstar. Morningstar does not make any representation regarding the advisability of investing in ETFs or ETNs that are based on Morningstar indexes.