Although Japan is perhaps mired in another ‘lost decade’ and faces significant obstacles on the road to material economic growth, the country remains the world’s second largest economy and as such is a major component of the international equity portion of most investor portfolios. After missing out on the bull market that sent much of the global equity market soaring in 2009, some analysts see 2010 as another poor year debt-burdened Japan. Goldman Sachs’ Jim O’Neill recently noted that in relation to America and Britain’s economies Japan’s is “much much worse“.
Despite the economic challenges, Japan remains a popular investment destination, particularly among investors who believe the market is still near its bottom, and that a slide in the yen could give the nation’s export market a considerable boost. The iShares MSCI Japan Index Fund (EWJ) is by far the most popular ETF offering exposure to Japanese equities, with nearly $5 billion in assets. But many investors have turned to small cap Japanese funds as a way to play a recovery in the world’s second largest economy, seeking out exposure to local economies while avoiding mega cap stocks.
Small Cap ETF Options
Japanese small cap funds can provide investors with valuable diversification benefits while still allowing for investors to have access to Japanese markets. In fact since mid 2006, EWJ and its small cap counterparts have had a correlation of about 0.65 and EWJ has underperformed its smaller Japanese funds by more than 6% over the time period. The small cap nature of these funds may also provide investors with greater growth opportunities than the larger Japanese firms which have far fewer growth possibilities left on the Home Islands.
EWJ is dominated in holdings by multi-national firms that generate significant portions of their revenues from overseas – Toyota, Honda, Sony, Mitsubishi, Panasonic, and Canon are all among the top ten individual holdings. These mega-caps are global brands that are generally already included in many global index funds and can trade on stock exchanges in the United States. This is not the case for the vast majority of the small cap Japanese firms; companies like Sotetsu Holdings or Yokogawa Electric Corp are generally inaccessible to most American investors.
There are currently three ETFs that offer small cap exposure to Japan Equities; WisdomTree Japan SmallCap Dividend Fund (DFJ), the SPDR Russell/Nomura Small Cap Japan ETF (JSC) and iShares MSCI Japan Small Cap Index Fund (SCJ). Although the three have a similar investment objective, there are a few key differences that investors should be aware of before choosing a fund.
The three funds all have their highest sector weightings in industrials and consumer discretionary products. Both DFJ and JSC have their third highest weighting as materials at around 14% while SCJ focuses on financials with a 17% allocation. Unsurprisingly, all three are underweight capital intensive industries such as utilities and energy, both of which account for less than 2% of each fund. As shown in the chart below, the funds have wildly divergent number of holdings but have very similar market capitalization levels.
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DFJ follows the WisdomTree Japan SmallCap Dividend Index which seeks to track the performance of dividend-paying small cap companies in Japan. The index removes the 300 largest firms and then the rest are chosen for inclusion in the index. DFJ weights companies in the index based on annual cash dividends paid.
SCJ follows the MSCI Japan Small Cap Index, targeting 40% of the eligible small cap universe within each industry group in the MSCI Japan Index (which consists of stocks traded primarily on the Tokyo Stock Exchange and have a market capitalization between $200 million and $1.500 billion). JSC follows the Russell/Nomura Japan Small Cap Index which tracks the smallest 15% of stocks in terms of market capitalization, of the Russell/Nomura Total Market Index.
Despite having vastly different holdings, the funds have performed remarkably similar over the past 52 weeks. JSC barely edges out SCJ with a return of 8.82% to 8.80%, but JSC has an expense ratio that is two basis points higher than SCJ at 0.55% to 0.53%. DFJ finished last in both categories with a 6.57% gain over the past 52 weeks and an expense ratio of 0.58%. The fund does however have the highest average volume and assets under management suggesting that the fund is probably the most liquid small cap Japan fund available.
Japanese equities look to be in focus this year as China looks to overtake Japan as the second largest economy and the country battles deflation and the possibility of a prolonged downturn. The question is whether Japan will be boosted by the high levels of Mainland Asian growth or if its economy will be left in the dust of its faster growing East Asian neighbors. Either way, small cap Japanese funds look to be a promising way for investors to diversify their foreign exposure while obtaining asset class diversification as well.
For investors who think Japan may perform relatively well this year, all three of these ETFs offer intriguing options. For those who believe in the benefits of a dividend-weighting approach, DFJ is probably the best choice. Those seeking the smallest possible Japanese securities by market capitalization while maintaining quality growth prospects may want to take a closer look at JSC. Investors seeking a low concentration in individual securities as well as a significant weighting to the Japanese financial industry might like SCJ.
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Disclosure: No positions at time of writing