2 Key Trends Benefiting Japan ETFs

ETF investors have plenty of ETF choices if buying into Japan is what they seek.

It could be time to take another look at Japan equity ETFs. The segment, which seems to have gone from hot to cold in the past few years, now appears to have two key trends in its favor.

The first is talks of a new deal with the U.S. that would involve massive investment, growth opportunities and beneficial trade deals for both sides. The second is attractive valuations for Japanese stocks, at least according to historical norms.

Here’s what to consider …

Positive Backdrop Includes Infrastructure Investment & Trade

Japan is looking to work closely with the U.S. on new trade deals and on massive infrastructure projects. A so-called “U.S.-Japan economic cooperation plan” that Japan’s Prime Minister Shinzo Abe is expected to unveil in the days ahead would include a $450 billion infrastructure market in the U.S. to be funded largely by Japanese investors.

According to WisdomTree’s Head of Japan Jesper Koll, “Japan would offer to seed-fund these projects with low-interest loans, mobilizing resources from Japan’s public pension fund and other public lenders.”

Abe is also expected to pursue bilateral trade agreements with the U.S. that would benefit various sectors of the Japanese market. Abe and U.S. President Trump are set to meet today and Saturday.

“If, as we suspect, the meeting goes well, the implications are poised to be positive for U.S.-Japan economic and financial relations,” Koll said. “Trump’s America and Abe’s Japan are a ‘match made in heaven,’ not just because both leaders share a basic ‘strongman leadership’ and ‘my country first’ philosophy, but because the economic and financial agendas are very much aligned.”

What this deal means to ETF investors is that infrastructure names, and applied robotics companies, should benefit almost immediately, and longer term, currency manipulation in that part of Japan will subside as trade agreements take effect, Koll says.

“Japan’s capital goods sector is poised to benefit most directly,” he added. “In addition, the greater and deeper the Trump-Abe relationship develops, the lower the risk of erratic bilateral frictions should become. Specifically, the more positive U.S.-Japan economic cooperation, the less likely it should get for Japan to be suspected of manipulating its currency.”

Stock Valuations Are Attractive

Japan is offering value, at least historically speaking.

In a blog this week, Charlie Reinhard, chief portfolio strategist at MainStay Investments, pointed out that Japan’s stock market’s valuations are low from a historical perspective. Look at the chart below from Reinhard’s commentary:

The chart shows the historical forward price-to-earnings (P/E) ratio of the Japanese stock market as being below its 1990-to-present average.

His takeaway: Japan is offering value.

ETF Choices: To Currency Hedge Or Not?

The ETF market has 28 Japan equity ETFs (nonleveraged or inverse) that investors can choose from. They run the gambit in terms of strategy, exposure, asset level, liquidity and cost, as you can imagine.

Perhaps the first question a U.S. ETF investor needs to ask is whether or not that exposure to Japan should be currency hedged. Currency hedging serves the purpose of mitigating currency risk associated with international stock exposure.

Returns on international equity ETFs come primarily from two sources: the price movement of underlying securities, and the impact of local currency fluctuations against the dollar. Currency-hedged ETFs take that currency exposure out of the equation.

The two biggest Japan equity ETFs track the same MSCI universe of stocks, but one is currency hedged and the other is not. They are the $16.4 billion iShares MSCI Japan ETF (EWJ) and the $8.4 billion WisdomTree Japan Hedged Equity Fund (DXJ).

Here is how they have performed in the past 12 months: 

Chart courtesy of StockCharts.com

Crucial here is what is going on with the currencies. Japan is still very much engaged with monetary easing, while the U.S. has turned away from easing. That has translated into strength for the U.S. dollar and weakness for the Japanese yen.

Currency-hedged ETFs tend to outperform their unhedged counterparts when the dollar is strong. Picking between the two options depends largely on your view on currencies and their outlook.

DailyFX, a service that offers technical analysis and outlook for currency moves, said this week that the dollar/yen pair could stay confined to a range at least until the Fed meets in March “especially as Chair Janet Yellen and Co. appear to be in no rush to further normalize monetary policy.”

While EWJ and DXJ are the two largest Japan ETFs, and the poster children for the to-hedge-or-not-hedge debate, there are other total market ETFs, including:

• Deutsche X-trackers MSCI Japan Hedged Equity ETF (DBJP) with $2.1 billion in assets
• iShares Currency Hedged MSCI Japan ETF (HEWJ) with $890 million in assets

Investors also have the option of partially hedging currency via the WisdomTree Dynamic Currency Hedged Japan Equity Fund (DDJP), which has $5.3 million in assets. DDJP offers exposure to Japanese stocks, and has a “dynamic” currency-hedging feature that offers partial exposure to upside movements in the yen and hedges out the downside.

Size Focus

ETF investors can also break down Japan exposure by other categories. The first is size. Instead of owning a total market ETF, there are small-cap funds offering hedged as well as unhedged exposure. Here are the top three:

• WisdomTree Japan SmallCap Dividend Fund (DFJ) with $450 million in assets
• iShares MSCI Japan Small-Cap ETF (SCJ) with $135 million in assets
• WisdomTree Japan Hedged SmallCap Equity Fund (DXJS) with $110 million in assets

Sector Focus

Sector is another area of focus, and only WisdomTree offers sector-specific Japan plays at this time. They are all still relatively small, but for sector specific bets, they’d fit the bill.

• WisdomTree Japan Hedged Financials Fund (DXJF) with $44 million in assets
• WisdomTree Japan Hedged Capital Goods Fund (DXJC) with $27 million in assets
• WisdomTree Japan Hedged Health Care Fund (DXJH) with $8 million in assets
• WisdomTree Japan Hedged Real Estate Fund (DXJR) with $7 million in assets
• WisdomTree Japan Hedged Tech Media & Telecom Fund (DXJT) with $1.4 million in assets

For a complete list of Japan-focused ETFs, check out our Japan ETF channel.

Contact Cinthia Murphy at [email protected]