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Focus on Small Cap ETFs for Japan Exposure

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After two years of strong growth, Japan failed to sustain its longest stretch of economic expansion since the 1980s, indicating a major blow to Prime Minister Shinzo Abe’s Abenomics. The world's third-largest economy contracted 0.6% in the first quarter of 2018, more than the expected 0.2% decline.

Lower business and household spending, the largest drivers of economic growth, were a drag. Higher vegetable prices due to bad weather have curtailed consumer spending in Japan. Additionally, export growth has lost momentum expanding just 0.6% in the first quarter after growth of 2.2% in the fourth quarter of 2017 thanks to weaker global demand for semiconductors and electronic parts.

However, many economists believe that the slowdown in the first quarter was temporary and that the Japanese economy will return to growth in the ongoing quarter. The could be easily depicted in solid manufacturing PMI data, which showed that business activity expanded at a faster pace in April as output and domestic demand picked up. The final PMI index climbed to 53.8 in April from 53.1 in March while the final index for new orders rose to 53.8 from 53.1. This indicates that the economy is recovering from a rough patch seen in the first quarter (read: 4 Reasons Why You Should Look at Japan ETFs Now).

Additionally, economic fundamentals look robust with rising wages and higher corporate profits. Inflation-adjusted real wages rose for the first time in four months in March, signaling a gradual increase in salaries that would stimulate consumer spending and give a boost to the economy. Corporate profits for the Japanese companies jumped 27% in the fiscal year ending in March – representing the second straight year of record profits. The big U.S. corporate tax cut will continue to accelerate corporate profits this year as well.

Moreover, Bank of Japan (BOJ) left its super-easy monetary era policies intact, indicating cheap money flows for some more months. Per the Reuters poll, more than half of the economists expect the BOJ to delay policy normalization until 2020 or later, courtesy of sluggish inflation (read: BoJ Mulling Over a Stimulus Exit: ETFs in Focus).

External Risks

A stronger currency and trade frictions will continue to dampen investors’ sentiments for the economy. Japanese yen, being considered a safe haven currency in times of uncertainty, has been rising as broad market worries lead to risk-off trade, spurring demand for the safe-haven assets. A strong currency has taken a toll on the prospects for Japanese exporters and the manufacturing industry. Notably, Japan is an export-oriented economy and a strong currency makes its exports expensive.

Meanwhile, trade worries between the United States and China might hurt growth further given Japan's importance as a source of parts and technology for products made or assembled in China. Trump’s protectionist stance will likely hurt global economic growth, thereby leading to a slowdown in economic activities everywhere, including Japan.

In particular, Trumps’ steel and aluminum import duty is expected to hit hard Japanese imports. In response to the retaliation against this tariff, Japan is mulling over levying charges on U.S. exports worth $409 million and is preparing to notify the World Trade Organization of the plan, a necessary procedure under global trade rules. The threat is likely to seek exemptions from the U.S. tariffs and is a similar move to China and the European Union, which responded to the U.S. decision with reciprocal threats (read: Country ETFs to be Impacted by Trump's Tariff Plans).

Given the dual headwinds but strong macro trends, investors should bet on small-cap Japanese ETFs, as these are less vulnerable to currency fluctuations or any other external threats.

Below, we take a look at three ETFs, which track the small-cap segment of the Japanese stock market. All of these funds offer access to pint-sized securities in the nation that are closely tied to the Japanese economy and do not have much exposure to the international market. These are likely to see higher volatility yet deliver better returns when the Japanese economy resumes growth.

WisdomTree Japan SmallCap Dividend Fund (DFJ - Free Report)

This fund targets the dividend-paying, small-cap stocks in the Japanese equity market by tracking the WisdomTree Japan SmallCap Dividend Index. Holding 755 securities in its basket, it has a spread out exposure to components as each firm holds less than 1.2% of assets. From a sector look, industrials and consumer discretionary take the top two spots with 26.2% and 22% share, respectively, while materials, information technology and financials round off the next three with a double-digit allocation each. The product has AUM of $1.2 billion and trades in a moderate volume of 87,000 shares. It charges 58 bps in annual fees and has surged 2.5% in the year-to-date time frame. The fund has a Zacks ETF Rank #1 (Strong Buy) with a Medium risk outlook.

iShares MSCI Japan Small-Cap ETF (SCJ - Free Report)

This fund follows the MSCI Japan Small Cap Index and holds 885 stocks in its basket with none holding more than 0.7% of assets. However, about one-fourth of the portfolio is allotted to industrials, closely followed by consumer discretionary (17.2%), information technology (12.3%), consumer staples (10.9%) and materials (10.1%). The fund has managed AUM of $560.2 million whiles sees a good average daily volume of around 126,000 shares. Expense ratio comes in at 0.49%. The fund has gained 3.2% and has a Zacks ETF Rank #1 with a Medium risk outlook (see: all the Developed Asia-Pacific ETFs here).

WisdomTree Japan Hedged SmallCap Equity Fund (DXJS - Free Report)

DXJS offers exposure to the Japanese small-cap stocks while at the same time provides hedge against any fall in the Japanese yen. This is easily done by tracking the WisdomTree Japan Hedged SmallCap Equity Index. The product holds 750 stocks in its basket with each accounting for no more than 1.2% of assets. Industrials and consumer discretionary are the top two sectors with 26% and 22% share, respectively, while materials, information technology and financials round off the top five. The fund has accumulated $205 million in its asset base and charges 58 bps in fees per year from investors. Volume is lower as it exchanges 48,000 shares in hand per day on average. The ETF is up 1.1% so far this year and has a Zacks ETF Rank #2 (Buy) with a Medium risk outlook.

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