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ETF Specialist

Is It Time to Start Looking at Japan ETFs?

A new ruling party pledges to revive the domestic economy, but obstacles abound.

In August 2009, the Democratic Party of Japan won a landslide victory over the Liberal Democratic Party, the incumbent party who had been in power for most of the last 54 years. While the LDP is credited for engineering a period of stellar economic growth from the 1960s to the 1980s, it is also faulted for failing to turn around Japan's stagnant economy over the last 20 years. In 2009, the DPJ easily defeated the LDP, with a platform pledging to improve the quality of life for the average Japanese person, shrink the bureaucracy, cut wasteful public spending, and strengthen Japan's economic ties with its Asian neighbors. However, since this decisive election, the performance of the Japanese markets has continued to remain lackluster, and over the last month, the Nikkei 225 Index has underperformed the S&P 500 and global developed market indexes. Does this present an attractive entry point for an investment in Japanese exchange-traded funds?

The DPJ plans to revive the domestic economy by providing a boost to the Japanese consumer through tax cuts and through more handouts to the elderly, parents, and the unemployed. The DPJ also seeks to better support small and medium-size business, a shift in focus from the LDP's big-business-friendly policies. Yukio Hatoyama, the newly elected prime minister, is also proposing greater economic and political integration with its Asian neighbors--stronger trade relations with China would certainly be a boon to Japanese companies.

For investors optimistic about the DPJ and a Japanese economic recovery, we would suggest investing in Japan small-cap ETFs. Generally speaking, broad market funds tend to have heavy weightings in large-cap multinational companies, whereas small-cap funds tend to hold more firms that serve primarily local or domestic customers. For example, top holdings for broad market Japan ETFs such as iShares S&P TOPIX 150 Index (ITF) and  iShares MSCI Japan Index (EWJ) include global firms such as  Toyota Motor (TM),  Honda Motor (HMC),  Canon (CAJ), Nintendo, and  Sony (SNE). We also highlight that while the consumer discretionary sector accounts for about a 20% weighting in both broad market and small-cap Japan ETFs, the companies in the consumer discretionary sector can be quite different in a broad market fund versus a small-cap fund. Global auto manufacturers and consumer electronics firms tend to dominate the consumer discretionary holdings in a broad market portfolio, whereas more domestic-oriented restaurants, retailers, and apparel manufacturers are represented in the consumer discretionary holdings in a small-cap portfolio. We also note that smaller financial firms tend to be more exposed to the domestic market, relative to large-cap financial firms. However, large-cap and small-cap firms in sectors such as industrials (capital goods), materials (commodities), and information technology (hardware, software, and semiconductors) in Japan tend to be export-oriented, either directly, or indirectly as a supplier to an export company. Since the elections in late August, broad market and small-cap Japan indexes have traded in line.

At this time, there are three Japan small-cap ETFs-- iShares MSCI Japan Small Cap Index (SCJ), WisdomTree Japan SmallCap Dividend (DFJ), and SPDR Russell/Nomura Small Cap Japan . While the holdings of these three funds are quite different, the sector weightings are fairly similar, and, as a result, the recent performance of these three funds is very similar. We think SCJ is probably somewhat more exposed to the domestic Japan economy, thanks to its relatively heavier weighting for financials. We also highlight that SCJ has the lowest expense ratio, at 0.53%, relative to DFJ and JSC, which have expense ratios at 0.58% and 0.55%, respectively.

Campaign promises are great and all, but there are a number of obstacles that could impede an economic recovery in Japan and weigh on Japanese equity markets. Politically, the DPJ has to deal with a deeply entrenched and powerful bureaucracy and a massive budget deficit, which currently stands at about 180% of annual gross domestic product. The global recovery could also start to falter as stimulus spending winds down and if central banks around the world tighten monetary policy too quickly. Another concern is the yen, which has been steadily appreciating against the U.S. dollar. It is unclear if the new administration would intervene to weaken the yen, and, to date, the new finance minister Hirohisa Fujii has given the market mixed messages about the administration's yen policy. Japan imports almost all of its oil and gas needs, and a higher yen would help local businesses and Japanese households. However, a higher yen would weigh on the exports of Japan's large multinational firms. Finally, we highlight that one of the most significant long-term concerns about the Japanese economy is the country's rapidly aging population, which will negatively affect Japan's labor market and weigh on social security programs. 

We are not very optimistic about a quick economic turnaround in Japan, and we also highlight that a recovery in Japan is somewhat dependent on the health of the U.S. consumer, who continues to remain weak. However, current expectations for the Japan market are relatively low, and a combination of new DPJ initiatives, plus a quick global economic recovery, could provide a good boost to the Japan economy. For those willing to place a bet on Japan, we think small-cap Japan ETFs are the way to go, but we recommend keeping these investments on a short leash.


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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.

Patricia Oey does not own (actual or beneficial) shares in any of the securities mentioned above. Find out about Morningstar’s editorial policies.