Reasons to be Wary of Two Popular ETFs

Judging from fund flows, trading volume, and requests we receive for new analyses, investor interest in a pair of exchange-traded funds, iShares MSCI Japan and iShares Dow Jones Select Dividend, is running high. Are these funds worthwhile? Possibly, but investors should make sure they understand what they're getting before diving into either one.

 IShares MSCI Japan Index (EWJ)
Through the end of April the iShares MSCI Japan Index was clearly one of the most popular funds of any type. It was among the 20 best-selling mutual funds so far in 2004 in terms of net inflows, garnering about $2.2 billion and edging out big name traditional open-end mutual funds such as  Fidelity Low-Priced Stock (FLPSX) and  American Funds Investment Company of America (AIVSX), according to Financial Research Corp. IShares MSCI Japan also is one of the most actively traded of all ETFs.

It's not surprising. The fund has gained more than 43% over the trailing 12-month period ending June 10, and, after years of stagnation and disappointment, there is renewed hope that the Japanese economy and stock market is finally growing again.

The fund offers broad exposure to larger Japanese companies, such as  Toyota (TM),  Canon (CAJ), and  Sony (SNE). And its 0.84% expense ratio, though high for an ETF, is a percentage point less than the average Japan mutual fund's. The fund also has done a decent job tracking its benchmark, the MSCI Japan Index, though the fund has been known to trade at discounts and premiums of more than 1% to its net asset value.

The fund, however, is capable of both staggering gains (it posted a market gain of more than 60% in 1999) as well as losses (it has fallen by double digits in four of the last seven years). And while there has been positive economic news out of Japan this year, the country is not out of the woods. Japan remains susceptible to fears of an economic slowdown in China as well as rising interest rates in the United States. Furthermore, not everyone is convinced Japan has embarked on the long-awaited sustainable recovery. As Morningstar senior analyst Gregg Wolper  has written, "While Japan's perennially troubled economy has strengthened, experts are split on whether this heralds a long-term revival or if structural problems in Japan's financial and political structures will hold it back for the long term."

Use this ETF sparingly if at all, and only if you already have a diversified portfolio. Indeed, if you own an international fund, you should see how much exposure to Japan you have currently. Just a little goes a long way.

 IShares Dow Jones Select Dividend Index (DVY)
We've gotten quite a few requests for an analysis on this relatively new offering from Barclays Global Investors (it's on the way, I promise). The interest in this fund also is understandable. Last year Congress passed and President Bush signed a law that lowered the tax on corporate dividends. The more favorable tax treatment as well as predictions of single-digit future equity returns from veteran investors as varied as Warren Buffett, and PIMCO's Bill Gross have led many to believe dividends will play a larger role in stocks' total returns in coming years.

As a cheap, pure play on dividend-paying stocks, this ETF has appeal. It tracks a benchmark created by Dow Jones that is composed of the 50 highest-dividend-yielding, non-REIT companies in the Dow Jones U.S. Total Market Index. At 0.40%, the fund's expense ratio is much cheaper than the average large- or mid-cap value fund's. The offering also has a lower levy than the typical member of the high-yield specialty fund categories--REITs, utilities, and convertibles.

The fund needs to be used properly, however. It won't provide broad-market exposure: Its dividend requirements virtually rule out software, hardware, and media stocks and lead to a preponderance of financial companies (roughly 42% of assets, with most of that in banks). So the ETF, which also owns big helpings of telecom and utilities, courts some sector risk. It's also skewed much more toward mid-caps than the broad U.S. stock market.

This ETF could add variety to a portfolio that hugs the growth side of the road. But it's no substitute for a broader fund, and investors need to be aware that its key area of emphasis--mid-cap value stocks--is an area that ran extremely hard during the bear market, and could be due for a breather. At the very least, before making a bet on the oft-predicted dividend-paying-stock-resurgence, investors should make sure they already have a diversified portfolio and check their existing exposure to value and high-yielding stocks.