Shifting Japan ETFs For Abenomics 2.0

Japanese equities have hit a rough patch in 2014, but for the next phase of Abenomics, DBJP looks favorable to DXJ.

Since late 2012, the $11.6 billion WisdomTree Japan Hedged Equity ETF (DXJ | B-52) has become the de facto way to play a currency-hedged, Abenomics-induced rebound in Japanese equities.

Still, DXJ is anything but a plain-vanilla, cap-weighted ETF.

While DXJ performed remarkably well over the past year and a half, a lesser-known currency-hedged competitor, the $454.1 million db X-trackers MSCI Japan Hedged Equity ETF (DBJP | B-57) performed even better.

Moreover, looking ahead, DBJP looks better positioned to capitalize on the next phase of Japan’s “recovery” for one big reason: full exposure to Japan’s financial sector.

What’s Next For Japan?

There’s no doubt that the hype around Abenomics—the economic program implemented by Japanese Prime Minister Shinzo Abe—has deflated some in recent months.

The Nikkei 225 Index has fallen more than 7 percent year-to-date on several factors, including a stronger yen, geopolitical tensions in Ukraine, a slowdown in China and foreign investors taking profits. The sales tax increase from 5 to 8 percent that went into effect April 1 only adds to investor concerns.

But above all, there’s been disappointment from a lack of follow-through in Abe’s structural reforms, his “third arrow.”

Still, from a contrarian perspective, hot money leaving Japan’s stock market may be creating opportunities. While Japan has witnessed numerous head-fakes in equity rallies over the past 2 decades, there’s some reason to believe that this time it really may be different.

For starters, Japan’s newly established tax-tree savings account, the Nippon Individual Savings Account (NISA), now offers a tax incentive to invest in the market. It could potentially jump-start a rotation of at least a portion of the trillions of dollars sitting in postal savings accounts into the stock market.

Success of the NISA program may not in itself spur a stock market rally but it would certainly be a break from the past that could lead to more public acceptance of investing in the stock market.

Mind you, in the mid-2000s, the Nikkei rallied sharply on the back of then-Prime Minister Junichiro Koizumi’s “revolutionary” plan to get its citizens to move their savings into the stock market by privatizing Japan Post. It never panned out.

That said, I think what’s different this time around is that Abe has a central bank governor, Haruhiko Kuroda, who seems fully committed to quash deflation once and for all with massive monetary stimulus and keep this rally going.

I myself have been a skeptic of Abe’s structural reforms for a while. But though I may not have much faith in Abenomics 2.0, in “Kurodanomics,” I trust.

Clearly, the two are tied together, but let’s face it: The Bank of Japan’s unprecedented monetary stimulus—the “second arrow” of Abenomics—is what really crushed the yen, causing equities to rally hard in 2013.

Should the new sales tax create deflationary pressures and weakness persist in the equity market, I wouldn’t be surprised to see the Bank of Japan unleash additional stimulus measures.

So getting back to ETFs, how does all this bode well for DBJP?

The Case For DBJP

Compared with DBJP, which follows a straight market-cap selection and weighting process, DXJ’s methodology is slightly more complex.

For starters, DXJ eliminates any company that derives 80 percent or more of its revenues domestically. Then, it weights its constituents by dividends paid.

Unfortunately, the resulting portfolio misses out on some major financial institutions that are poised to benefit the most if the NISA program is eventually successful in getting the Japanese to start participating more heavily in the stock market rally.

As you can see in the table below, DXJ severely underweights financials compared with DBJP and the MSCI Japan Investable Markets Index, our benchmark for our Japan Total Market segment.

Sector/Industry Breakdown

Source: ETF.com

Not only does DXJ exclude some of Japan’s largest financial institutions, such as Sumitomo Mitsui Financial and Mizuho Financial Group, it also excludes major real estate developers.

In a scenario where “Abenomics 2.0” falters and the Bank of Japan is forced to kick “Kurodanomics” into high gear, causing a further slide in the yen, the real estate sector could be a real winner.

Therefore, for Japan 2.0, I would prefer to have full exposure to Japan’s banks, brokerages and real estate firms.

Finally, DXJ excludes telecoms. While big telecom companies like Softbank, KDDI Corp., Nippon Telegraph and Telephone, and Docomo may not immediately come to mind when investors think of Abenomics, the risk-averse Japanese public may choose to buy Japanese mega-caps in their NISA accounts, as Jim Rogers pointed out in a recent interview with ETF.com.

DBJP’s lack of liquidity and assets were a major concern with the fund during “Abenomics 1.0,” but the fund has come a long way since the end of 2012. It now has over $450 million in assets and averages around $6 million a day at 14 bp spreads—liquid enough for retail investors.

For larger investors looking to create in size, the $8.5 million iShares Currency Hedged MSCI Japan ETF (HEWJ) is also an option. HEWJ tracks the same index as DBJP, and creations are done using the ultra-liquid $14 billion iShares MSCI Japan ETF (EWJ | B-97), so the fund has great block liquidity.

There’s no denying that DXJ still trumps DBJP in holding and trading costs—over a typical 12-month period, DXJ tends to lag its index by about 50 bps less than DBJP lags its index. DXJ also trades close to $300 million on most days, at spreads of 2 basis points.

That said, I just wonder if DXJ’s methodology to tilt toward exporters might, ironically, end up working against it in the second phase of Japan’s recovery.

On the one hand, you now have a major tax incentive for Japanese to invest in stocks, which should benefit the financial sector.

If the new sales tax chokes off growth, causing the Nikkei to slide and the yen to surge, many analysts now expect the Bank of Japan to increase stimulus in the coming months.

That’s why whether Abenomics 2.0 comes to fruition, or whether it disappoints and leads to more stimulus from the Bank of Japan, DBJP and HEWJ continue to look more favorable than DXJ for broad, currency-hedged exposure to Japanese equities.

At the time this article was written, the author held no positions in the securities mentioned. Contact Dennis Hudachek at [email protected], or follow him on Twitter @Dennis_Hudachek.