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For Japan ETFs, Think Small Caps

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2011 was another rocky time for Japan as the year started off pretty well for the country as stocks moved sharply higher in the first two months of the period. Yet, as we all know, this wasn’t meant to last as the earthquake and subsequent tsunami that hit Japan in March of 2011 were among the most destructive natural forces in history. In addition to over 15,000 deaths and hundreds of billions in damages, the disaster also led to a nuclear meltdown, an event that we are still learning the full scope of.

Yet despite this devastation, and the huge sell-off in everything Japanese after the initial crisis, the country has rebounded quite nicely in the months following the disaster and appears to be nearly back on its feet. Assets have been flowing into the nation at a robust rate, helping to bid up securities across the nation. In fact, the most popular Japanese ETF, the MSCI Japan Index Fund (EWJ - Free Report) saw inflows of close to $1.3 billion in the past one year period, suggesting high levels of demand for these securities (read Ten Best New ETFs of 2011).

In addition to searching for beaten down stocks and bargain buying after the quake, Japan has benefited from being a decent option in an uncertain time. Slowdowns are impacting a variety of nations around the globe and debt burdens are threatening to crush Europe. While Japan certainly has a heavy burden itself, the country’s high savings rate and large level of domestic participation in government bond buying are still managing to put investors at ease for the time being. It also hasn’t hurt that the country has an extremely low discount rate and can easily borrow in its own currency, at least at this time.

Beyond stocks in the country, the yen has also seen a surge in popularity as well. In addition to those flowing into the equity market, the surge in yen demand is likely due to massive levels of Japanese repatriation of assets in order to help pay for rebuilding costs.  As a result, the currency has continued to rise against the dollar and is currently testing levels around the 77 yen mark against the greenback sharply closer than the 52 week high of 85.5 that investors saw immediately following the quake (read Three Outperforming Active ETFs).

Yet while the economy of Japan has been surprisingly resilient in light of these forces, the stock market hasn’t. Major benchmarks in the nation have slumped, continuing the country’s nearly 20 year ‘lost decade’ for large cap equities. While the situation isn’t good, there is some hope for those looking to put assets to work in the nation’s small caps instead. These pint sized securities could be the go-to asset class thanks to a number of factors stemming from both the current economic environment and the resulting investment climate in the country post-tsunami.

Small Caps In Focus

First, investors should note that small caps tend to take their cues from the domestic economy instead of global events. This could help them to skirt the worst of the crisis in many developed nations and some of its major emerging market trading partners as well. Additionally, and more importantly, is the issue of the strong yen and its impact on small caps.

Generally speaking, small caps in this country could benefit from a stronger currency as they do not do a lot of exports but see a great deal of imports. This could help to keep the price of commodities, such as oil, reasonable in yen terms giving consumers in the country more to spend domestically. Obviously, these trends have pretty much the reverse impact on exporters as a stronger currency makes their products less competitive on the global stage forcing profit margins to slump for these key businesses (see Brazil Small-Cap ETF Showdown).

Thanks to these issues, it is clear that small caps in Japan could outpace their larger counterparts again in 2012. Luckily for investors seeking to make a play on the space, there are a few options available that can offer diversified exposure to the space. 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:

iShares MSCI Japan Small Cap Index Fund (SCJ - Free Report)

This ETF tracks the MSCI Japan Small Cap Index which is a diversified benchmark of companies domiciled in Japan. The product holds over 700 securities in its portfolio and puts just under 5% of total assets in its top ten holdings, suggesting virtually no company specific risk. In terms of sector exposure, industrials and consumer discretionary both take up slightly more than 20% although financials round out the top three with just under 18.2%. The product charges 51 basis points a year in fees but pays out a solid dividend yield of just under 2.8% in 30 Day SEC Yield terms (also read Time To Consider The Small Cap Oil ETF).

WisdomTree Japan Small Cap Dividend Fund (DFJ - Free Report)

For another way to play the space, investors should consider DFJ, a product that tracks the WisdomTree Japan Dividend Index. This benchmark weights securities based on annual cash dividends paid, giving the biggest weights to those that pay the biggest dividends. Ironically, this gives the fund one of the lower yields in the space at just 1.9% in 30 Day SEC Yield terms while fees come in at 0.58% a year. For holdings, industrials and consumer discretionary firms both take up more than 21% of assets while financials again round out the top three although just at 13.2% this time.

SPDR Russell/Nomura Small Cap Japan ETF

For the ETF with the most holdings in the space, JSC is the way to go as the fund has more than 1,000 securities in its benchmark. Top holdings by sector include the usual suspects of industrials, consumer discretionary and financials, although JSC is slightly more top heavy than the others on the list. In terms of market cap for these underlying holdings, the weighted average is just $564 million while the largest company is just $2.7 billion. Meanwhile, for dividends and expenses, these are both in line with the other small cap Japan ETFs, as the product pays out a little more than 2% but charges investors close to 55 basis points a year in fees (see Three Micro Cap ETFs To Play The January Effect).

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