Japan ETFs Trading for Book. Is the Land of the Rising Sun Cheap Enough?


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There is Asia and then there is Japan. For a decade ETFs representing markets in China, Hong Kong, Singapore, Australia, Korea have been some or the best performing in the market. For a decade, Japanese ETFs have been among the worst-performing. What is wrong with Japan? Can anything pull Japanese ETFs out of the mire?

The situation in Japan is well-known. The post-war miracle boom peaked in the eighties as a surge in domestic Japanese demand supplemented export revenue. During the eighties, investment in Japan was fueled by an increasingly valuable currency that made foreign assets cheap for Japanese and drove up prices at home. Prices of stock and real estate skyrocketed-- then collapsed. Banks with massive portfolios of non-performing loans became insolvent. Japan has never recovered from this bust. The chart below shows the long-term performance of the Japanese stock market index, the Nikkei.

Short of throwing money out of helicopters, it is probably fair to say that the Japanese have tried just about everything to spur their economy rate cuts, currency management, spending, stimulus. Despite this, Japan today has multiple ills widely considered intractable: lack of domestic demand, poor demographics (an aging population), persistent deflation, and massive debt. Macro numbers are staggeringly bad. Japans debt is about 200% of GDP, the highest by this measure in the world after Zimbabwe. S&P recently cut Japans debt rating to AA-, its fourth highest rating.

The usual cure for too much debt is to increase growth by spurring investment and consumption. On the investment side, the Bank of Japan has had interest rates essentially at zero for a decade. Money is already free. It is hard to go further. On the consumption side, the Japanese consumer, though prodded prefers to save. Currently below 60% of GDP, consumption lags the U.S. and Europe. This makes it difficult for Japan to grow its way out of debt. Unlike in the U.S., where a lot of debt is owned externally (by China and others), most of Japans debt is owned internally, to its citizens, who in the wake of the Japans banking crisis mistrust banks. This leaves Japan vulnerable to its demographics. As its citizens age they will need some of the money they have invested in Japanese bonds.

But surely some of this is priced in? Maybe but, with the exception of a big run in 2003, Japanese ETFs have not kept pace with the rest of Asia. The chart below compares the granddaddy of Japanese ETFs, the iShares MSCI Japan (NYSEArca:EWJ) with FTSE China (NYSEArca:FXI), Hong Kong (NYSEArca:EWH) and Australia (NYSEArca:EWA).

The chart shows that over five years Asian ETFs of did well. Japan's EWJ provided investors with negative returns. (But notably it did not suffer the steep drop during the financial crisis of Chinas FXI). Though most investors do not look to Japan for growth, ETFs like EWJ are good for diversification and stability. Japan is stable both economically and politically. According to Country Watch, which publishes a political stability index, Japans politics are highly stable, with a score of 9.5 of a possible 10.

Still, some investors dare to hope for more. They argue that investors should be willing to pay more for stability, not less. Typically Chinese stocks trade at multiples of book value. By this measure Japan is cheap. Shares of well-established companies like Mitsubishi Financial and Toyota Motors, big holdings in Japanese ETFs trade at and even below book value.

In addition to EWJ investors looking for exposure should consider WisdomTree Japan Hedged Equity (NYSEArca:DXJ) and small cap funds, Japan Small-Cap Dividend (NYSEArca:DFJ) and SPDR Russell/Nomura Small Cap Japan (NYSEArca:JSC). For property exposure iShares FTSE EPRA/NAREIT Developed Asia Index (Nasdaq:IFAS) offers about 25% exposure to Japan.

Other than the valuation argument, the best thing for Japan ETFs would be restarting the machine that powered it to the world's second largest economy in the sixties and seventies: export. If China is the big winner of globalization, then the U.S. and Japan are the big losers. Japans export machine has slumped as China has become the worlds manufacturer. Chinas currency policy in particular has hurt Japanese exports. The Chinese currency is pegged to the dollar. The euro and the yen have had to weaken against a dollar prevented from weakening against the Chinese yuan. The yen now stands at decade long highs against the dollar. This makes it difficult for Japanese companies to export.

The fate of Japanese export ambitions may be decided in Beijing. If China allows the dollar to fall against the yuan, this will take some pressure off the yen. A weaker yen would mean more demand for exports. If the dollar strengthens against the yen, as it has been recently, Japanese ETFs will lose value in dollar terms. An ETF investor wants a yen weak enough to permit exports and encourage asset prices to increase and strong enough to keep the value of Japanese holdings from substantial depreciation in dollar terms.

Below a list of key Japanese ETFs and expense ratios:

iShares MSCI Japan (NYSEArca:EWJ), 0.54%

iShares MSCI Japan Small Cap Index Fund ( SCJ ), 0.53%

iShares S&P/TOPIX 150 Index Fund ( ITF ), 0.50%

ProShares UltraShort MSCI Japan Fund ( EWV ), 0.95%

SPDR Russell/Nomura Small Cap Japan ETF ( JSC ), 0.55%

WisdomTree Japan High-Yielding Equity Fund ( DNL ), 0.58%

WisdomTree Japan Small Cap Dividend Fund (DFJ), 0.58%

WisdomTree Japan Total Dividend Fund (DXJ), 0.48%

iShares FTSE EPRA/NAREIT Developed Asia Index (Nasdaq:IFAS), 0.48%

Jonathan Bernstein has been writing about ETFs since 2003 and is the author of Sector Trading: A Year in Exchange Traded Funds .

The views and opinions expressed herein are the views and opinions of the author and do not necessarily reflect those of Nasdaq, Inc.

This article appears in: Investing ETFs
Referenced Stocks: DNL , EWV , ITF , JSC , SCJ

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