ETF investors that want international exposure in their portfolios are likely going to gravitate towards global funds with a heavy allocation to Japanese stocks. This large allocation is simply a function of Japan being the third largest economy in the world and second largest developed nation behind the United States and China. As a result, it’s reasonable to assume that Japanese companies would be core holdings in a diversified basket of developed foreign nations.
However, this vary same overweight exposure to Japanese stocks is one reason that many broad-based international ETFs have stalled this year. One look at the iShares MSCI Japan ETF (EWJ) tells a very notable tale of a market that has not been able to generate any forward momentum for well over a year now. The increasing volatility and erratic price swings have failed to instill a sense of confidence among international investors.
One potential reason for this disruption has been the strength in the CurrencyShares Japanese Yen Trust (FXY) which has been steadily increasing since the beginning of the year. As a result of quantitative easing measures by the Japanese central bank, the currency and equity markets have shown increasing negative correlations. Simply put, a rising yen is seen as a headwind for Japanese stocks.
The trickle down effect of this sideways price action in Japanese equities has weighed on well-known international funds such as the Vanguard FTSE Developed Markets ETF (VEA). This ETF is designed to provide exposure to large and mid-cap companies of developed nations excluding the U.S. and Canada. VEA currently encompasses 1,370 stocks with Japan being the largest single country allocation at 19.90%.
When you compare the 52-week returns of VEA versus a more Europe-centric portfolio such as the Vanguard FTSE Europe ETF (VGK), you can see that the difference has amounted to a performance disparity of approximately 10%.
The other notable difference between these two broad international indices is that VEA has a 7.70% allocation to Australia as well. Australian stocks have rallied this year, but struggled to find traction in 2013. The net effect over the last 12-months is nearly a wash in total return.
Right now it appears that all the overseas developed country momentum during the last year is firmly rooted in European economies. The largest country exposure in VGK includes the United Kingdom, France, Germany, and Switzerland which together make up over 73% of the total holdings. Currently this ETF has exposure to over 500 individual companies and controls $15.8 billion in total assets.
In my opinion, unless Japan unleashes another wave of quantitative easing that is aimed at devaluing its currency, this trend of underperformance is likely to continue. My recommendation is to closely screen any international holdings to understand the impact of Japan exposure on your total portfolio. The transparency and up-to-date information that ETF sponsors provide make this a very easy task. You may find that there are other international opportunities that warrant increased exposure in light of this analysis.
International ETFs can be an excellent low-cost way to access global markets and provide diversified returns in equities outside of the United States. However, it is important to keep a close eye on outsized country or sector exposure that can have a noticeable influence on total returns.
Disclosure: As of this writing, the author had no positions in ETFs mentioned.