Japan’s Rising Sun Shines On ETFs Differently

Todd Rosenbluth is director of ETF and mutual fund research at CFRA.

Last week, Japanese Prime Minister Shinzo Abe’s Liberal Democratic Party (LDP) and its coalition partners scored a convincing win that will maintain a large majority in both houses of parliament.

This should extend the life span of “Abenomics,” including the Bank of Japan’s mega stimulus, and help Japan’s economic prospects, according to US iShares Investment Strategist Tushar Yadava. While Japan is the largest of the developed international markets, exposure in popular ETFs can differ.

Developed and diversified international equity ETFs have been very popular in 2017, with the iShares Core MSCI EAFE (IEFA) and the Vanguard FTSE Developed Markets (VEA) gathering the second-most ($19 billion net inflows) and third-most ($16 billion) new money year-to-date through Oct. 27, according to ETF.com data.

An additional $9.5 billion and $3.6 billion flowed into the iShares MSCI EAFE (EFA) and the Schwab International Equity ETF (SCHF), respectively, this year. The performance success of these ETFs has been aided by a rebound in Japanese equities.

Japan-Focused ETFs Climb

The iShares MSCI Japan (EWJ) and the WisdomTree Japan Hedged Equity (DXJ), the two largest Japan-focused ETFs, climbed by 20% and 19%, respectively, in 2017, after generating low single-digit returns in 2016.

According to Yadava, robust domestic activity, including unemployment at 25-year lows and a stable-to-softer yen, spurred solid corporate earnings growth in 2017; earnings are forecasted to grow 6.7% in the next 12 months according to Bloomberg consensus estimates.

EFA has a significant weighting in Japan (23% of assets), but offers some country diversification not found in EWJ and DXJ. European markets, including the U.K. (18%), France (11%), Germany (9.6%) and Switzerland (8.0%), are well-represented for this ETF.

Meanwhile, IEFA has slightly more exposure to Japan (24%) and less exposure to France (9.7%), as it has greater small-cap exposure than its sibling. In addition, IEFA has an expense ratio of 0.08%, lower than EFA’s 0.33%.

IEFA’s expense ratio is more comparable to VEA, which charges 7 basis points. However, as Rusty Vanneman, chief investment officer at ETF strategist firm CLS Investments, explained to CFRA, investors are focusing too much on fees and forgetting about holdings and expected returns.

Different Country Exposures

Indeed, VEA has 21% of its recent assets invested in Japan and 16% in the U.K., less than EFA and IEFA. That’s because Vanguard tracks an index that includes Canada (8.4% of VEA’s assets) and South Korea (4.4% of VEA’s assets; the two iShares ETFs, IEFA and EFA, do not include stocks from those two countries).

Meanwhile, SCHF also has 21% of assets in Japan, but has less exposure to Canada (6.6%) and South Korea (4.2%) than VEA; SCHF has a slightly lower expense ratio, 0.06%. Both VEA and SCHF track FTSE Russell indices, while the iShares ETFs seek to replicate MSCI benchmarks.

Why Japan Small-Caps Are Ripe

Turning to a different capitalization category, CFRA thinks smaller-cap companies can benefit as a local economy improves more so than large-cap firms that have more overseas exposure. Indeed, Michael Jones, chairman and CIO of ETF Strategist RiverFront Investment Group, thinks the economic reforms Japan is undertaking are favorable for the country’s young innovative companies.

The iShares MSCI EAFE Small Cap ETF (SCZ) has relatively high exposure to Japan (30% of assets) among the diversified international equity ETFs we analyze. The ETF has a weighted average market cap of $2.7 billion, with stakes in lesser-known companies such as industrials Daifuku and Furukawa Electric, but not Sony Corp and Toyota Motor. Relative to the larger-cap-focused iShares products, SCZ has less exposure to Germany (6.8%) and France (4.6%).

Another developed international small-cap ETF, the WisdomTree International SmallCap Dividend Fund (DLS), has 26% of its assets invested in Japan. However, the ETF’s dividend focus has resulted in greater exposure to Australia (13% vs. 6.2% for SCZ).

CFRA has rankings on approximately 1,050 equity ETFs and data on several hundred others. A low expense ratio is just one of many parameters we incorporate in determining an ETF’s proprietary ranking; other inputs include an analysis of the prospects of underlying holdings, bid/ask spread and technical trends. To learn more, visit https://bit.ly/2iiHAcR.

At the time of writing, neither the author nor his firm held any of the securities mentioned. Todd Rosenbluth is director of ETF and mutual fund research at CFRA, an independent research firm that acquired S&P Global Market Intelligence's equity and fund business in October 2016. He can be reached at [email protected]. Follow him at @ToddCFRA.