Sector-Specific Japan ETF Returns Vary

Japan’s reform storyline is still unfolding under Prime Minister Shinzo Abe’s leadership, and investors who’ve bought into Japanese equity ETFs—particularly currency-hedged ones—have now captured some of the strongest stock market returns globally this year.

If owning a fund like the WisdomTree Japan Hedged Equity (DXJ | B-64) or the Deutsche X-trackers MSCI Japan Hedged Equity ETF (DBJP | B-76) has been a good play relative to other global markets, owning specific Japan-sector ETFs might have been even better—if you picked the right one.

Sector Return Dispersion
The dispersion between the best performing Japan sector ETF and the worst, year-to-date, is a wide 20 percentage-points.

A position in the health-care-focused WisdomTree Japan Hedged Health Care (DXJH | C-63) has delivered total returns of 22 percent so far this year, but the real estate fund WisdomTree Japan Hedged Real Estate (DXJR | C-53) is down 2.4 percent so far in 2015. Going back a full 12 months, that dispersion hits 30 percentage points between the two ETFs.

To be clear, ETF investors currently have only five ETFs to choose from in this segment, and they are all still relatively new and small funds.

The good news is that they are all currency-hedged plays—a boon at a time when the yen continues to devalue against the U.S. dollar—and their performances do offer a glimpse into the sector opportunities in Japan if making sector-specific bets internationally is your thing.

The chart above plots the YTD performance of the five sector funds:

• WisdomTree Japan Hedged Health Care (DXJH | C-63), $13.7 million in AUM
• WisdomTree Japan Hedged Financials (DXJF | C-69), $29.3 million in AUM
• WisdomTree Japan Hedged Real Estate (DXJR | C-53), $28.9 million in AUM
• WisdomTree Japan Hedged Tech, Media and Telecom (DXJT | C-54), $4.1 million in AUM
• WisdomTree Japan Hedged Capital Goods (DXJC | C-51), $2.4 million in AUM

The Big Picture: Why Japan?

Consider the big picture: In the past 12 months, Japan was among the best-performing countries in the All Country Word Index in local currency terms, according to David Allen of Accuvest.

Even after August steep correction, a fund like the WisdomTree Japan Hedged Equity (DXJ | B-64) is still up 10 percent on the year. DXJ is heavily allocated to exporting industrial firms, but health care represents about 8 percent of the portfolio.

To put that performance in perspective, the unhedged iShares MSCI Japan (EWJ | B-99) returned a loss of 0.2 percent in the past 12 months as the yen weakened against the dollar. The SPDR S&P 500 (SPY | A-99), representing the broad U.S. stock market, is down 1.2 percent in the same period.

Charts courtesy of StockCharts.com

From a valuation perspective—as measured by P/E ratio—Japanese equities are not cheap, but they are relatively attractive, as they remain well below levels seen in recent years, and below other key developed-market levels.

“Valuations have become a bit more expensive, but Japan is still trading at a discount to the U.S. and Europe,” Allen said. “The fundamentals are strong and we are seeing accelerating leading indicators.”

What About Growth?

“There is no question that growth appears to be getting increasingly scarce in the world,” Jesper Koll, CEO of WisdomTree Japan, said in a recent blog. “All said, while export growth remains stuck in its correlation to global demand, Japan’s domestic demand is set for an endogenous and steadfast recovery.”

That recovery, he said, is expected to benefit small and midsize companies the most. From a sector perspective, Koll argues that Japanese financials and health care sectors will gain, and so far this year, that has been the case, as these two sector ETFs have led the pack, with double-digit gains.

A Contrarian Opportunity?

But while health care and financials have been strong, it’s in the laggard real estate sector that Stuart Quint, of Brinker Capital, sees the most opportunity going forward.

“What’s interesting about looking at sectors is that you can think of them as being in the early- and late-cycle stages of the market and the economy, which has had its fits and starts in terms of GDP,” he said. “From the low in 2012, you’ve had huge gains, but if you look at the price of land, it’s up barely 3 to 5 percent.”

“You’ve had a big real estate bubble in the ’80s and ’90s, and Japan had a huge hangover from that, but the fact is that if you look at metropolitan areas, offices and retail, there are very low vacancy rates; interest rates are low. This is more of a later-cycle sector,” he said.

From that perspective, the laggard performer has some catching up to do, Quint says, as supply constraints and demand growth kick in. To Quint, the real estate sector shows the most promise for the second half of the year.

However, Accuvest’s Allen says betting on real estate might be a bad idea.

“Real estate is the second-most-expensive sector within Japan on a P/E basis and is also expensive compared to global real estate as a whole,” he said.

“While Abe’s three arrows and inflation specifically will be positive for real assets, we think a lot of that is already priced into the real estate sector,” Allen added. “We would advocate for a more diversified allocation to Japan as opposed to focusing on a particular sector.”

Eye-To-Eye On Financials

If the two asset managers disagree on the outlook for real estate, they—and Koll—seem to agree that the outlook for financials is solid. To Quint, financials are his No. 2 sector pick for the rest of the year, because banks are still pretty cheap globally speaking, and Abe’s reforms should bode well for the financials sector, he says.

“Financials still have more room to run from our perspective, as they are a value play within Japan and will benefit from a steepening yield curve,” Allen agreed. “Overall, we think Japanese companies will continue to benefit from improving global demand, yen weakness and lower oil prices, as well as resilient domestic demand.”

Contact Cinthia Murphy at [email protected].