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The recession had hit hard the Japanese economy with risk-averse investors avoiding volatile assets like stocks. However, the economy’s fate seems to have changed ever since Prime Minister Shinzo Abe came into power after the mid-December elections.

The once struggling Japan economy, under Prime Minister Shinzo Abe, has seen asset prices shoot up, largely thanks to attempts to end deflation and weaken the yen. The Nikkei and broad Japanese stocks are roaring to multi-year highs as Bank of Japan (BOJ) continues with its aggressive monetary easing policy.

In fact, in an effort to curb deflation and further weaken the yen, BOJ recently disclosed another plan which was much more aggressive than expected. This pushed the market and stocks into bullish territory (DXJ--Best ETF to Play the Japan Rally).

BOJ’s New Plan

The BOJ entered into a new era of monetary easing, which included a huge inflow of money into the financial system that has suffered from very low levels of spending and borrowing. The central bank revealed its plan to expand the money supply and achieve the 2% inflation target within a span of two years.

The BOJ's plans include buying $530 billion a year in government bonds. The BOJ embarked on this plan with an intention to keep interest rates low.

This will eventually spur spending and borrowing in an economy which has suffered from stumpy business activity and low levels of consumer spending. The central bank has also unveiled its plan to buy riskier assets such as exchange traded funds and real estate trusts.

The impact of this stimulus package plan by BOJ on the market is quite evident in the moves of Japanese Indexes and stocks. In fact, Nikkei soared to levels not seen in the last four years, and is now up 25% since the start of 2013.

At the same time, Shinzo Abe appears to be quite successful another front, namely in the depreciation of the yen. The measures taken by the bank to ease monetary policy resulted in further weakness in the yen (Japanese Yen ETFs: Any Hope in 2013?).

The Japanese yen has tremendously declined against the U.S. dollar and euro in the past four days, and indeed over the past few months as well. Furthermore, many expect this trend to continue far into 2013 as well, suggesting more pain could be ahead for this currency.

While the yen’s sharp decline has fueled the surge in Japanese stocks and ETFs, the impact on The CurrencyShares Japanese Yen Trust (FXY) has been just the reverse. The fund has slumped to the extent of 14% in the year-to-date period on account of the weak yen.

FXY which has been designed to provide exposure to Japanese yen is the worst performing ETF in the developed market currency ETF space this year. Moreover, no better performance can be expected out of the ETF going forward as the yen is expected to further go down in BOJ’s attempt to stir up inflation and aid the economy.

FXY manages an asset base of $141.1 million and trades at volume levels of more than 1 million shares a day. The fund charges a fee of 40 basis points annually.

On the other side of the coin, the depreciation of the yen has turned in favor of an export oriented economy like Japan. Japan relies more on exports for growth and the slide in the yen has provided a boost to the nation’s export. A weaker yen makes their products more competitive on the global stage shooting the profit margins up for these key businesses (Q1 ETF Asset Report: Japan ETFs Reign).

In order to tap this growth in basket form investors should turn to small cap Japanese funds as a way to play a recovery in the world’s second largest economy, seeking exposure to local economies while avoiding mega cap stocks.

Below, we highlight some of the key details in the small cap Japan ETF space for those looking to make an allocation to the area for their portfolios:

WisdomTree Japan SmallCap Dividend Fund (DFJ)

For better access to Japanese markets, investors can look to invest in small cap securities of Japan through DFJ. This is best suited for Japan-focused investors seeking to invest in dividend paying small cap firms (For Japan ETFs, Think Small Caps).

DFJ is the most liquid small cap fund with the highest trading volume and assets under management in the small cap space. It includes firms in its holding based on annual cash dividends paid.

The ETF manages an asset base of $187.3 million and is home to 482 small cap securities. Industrials, consumer discretionary, financials, and materials enjoy double-digit allocation in the fund.

The fund’s performance has been quite remarkable in the year-to-date period delivering a return of 11.56%. The fund charges a fee of 58 basis points annually.

iShares MSCI Japan Small Cap Index Fund (SCJ)

This ETF tracks the MSCI Japan Small Cap Index which is a diversified benchmark of companies domiciled in Japan. The product manages an asset base of $60.5 million and holds over 724 securities in its portfolio.

The fund puts just under 6.24% of total assets in its top ten holdings, suggesting virtually no company specific risk. The product charges 51 basis points a year in fees

In terms of sector exposure, financials and industrials both take up slightly more than 20% and consumer discretionary round out the top three with 19.9% of the asset base.

SCJ has returned 15.66% in the year-to-date period.

SPDR Russell/Nomura Small Cap Japan ETF (JSC)

JSC provides exposure to 388 small cap securities of Japan and manages an asset base of $70.63 million. The fund charges a fee of 55 basis points on an annual basis. Company-specific risk is not an issue for this fund and so is concentration risk in the top ten holdings which stands at a mere 6.24%.

Among sector holdings, the top three are the usual suspects, namely, industrials, consumer discretionary and financials. Information technology firms also get double-digit allocation in the fund. The fund has returned 15.28% in the year-to-date period (Japan ETFs Stumble, Can They Regain Footing?).

Bottom Line

Shinzo Abe's goals clearly focus on monetary policy easing, debt financing and considerable spending on infrastructure in order to back inflation and boost the Japanese economy. However, investors should note that ample liquidity in the market may result in an artificial rise in asset prices.

Currently, Japanese ETF investments are looking more interesting as we move forward in 2013. This is especially true if the current trend in the market place holds and more gains are seen in Japanese stocks.

If this continues, any of the small cap ETFs listed above could make for solid picks. Plus, since much of the focus on Japan has been on large caps like (DXJ - ETF report) and (EWJ - ETF report), these funds could still be overlooked and prime choices for investors to play the real story in the domestic Japanese market.

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