Stock prices in Japan are still 60% below their peak in 1989. Despite positive returns over the last few years, the land of the rising sun may still have plenty of room to run. Japan has been in China's shadow recently, and with good reason, since the Japanese economy hasn't been firing on all cylinders. But that doesn't mean Japan should be ignored. In fact, it may be a worthy consideration for investors seeking an alternative to the much-hyped China and India plays.
One of the easiest ways to participate in the Japanese market is through the handful of ETFs that invest in Japan. There are now eight Japan-focused ETFs for American investors, seven of which are equity funds and one of which is a currency option. SSGA and BGI each have two offerings, while WisdomTree has three and Rydex one currency fund. Expense ratios for these eight funds range from 0.40% for the Rydex fund to 0.58% for a couple of the WisdomTree funds, and are moderate for country funds.
SSGA listed two Japan-focused SPDRs in late 2006, based upon indices created by the Russell Investment Group and Nomura Securities. One of these funds is made up of large-cap stocks, and the other has small cap in its name but is heavily invested in medium-cap companies.
The ETFs from SSGA include the SPDR Russell/Nomura PRIME JAPAN
The second Japan SPDR fund is the SPDR Russell/Nomura Small Cap Japan
BGI has two iShares offerings that came to market a number of years prior to any of the other ETFs. In addition to longevity, the iShares also share a primary focus on investing in large companies. The iShares MSCI Japan Index Fund
The two are very similar, and their largest positions are Toyota, Mitsubishi Financial, and Mizuho Financial. In addition, their heavy sector exposures in financials, consumer discretionary, and industrials closely follow one another. Open up the kimono a little further, and the two funds start to differ when their portfolio holdings capitalization is broken down. The iShares S&P/TOPIX 150 has the vast majority of its assets in large caps, while the iShares MSCI Japan Index Fund holds large caps but also puts roughly 11% of its assets into medium-cap companies. Both funds have moderate expense ratios of 0.50% and 0.54% for the iShares S&P/TOPIX 150 and the iShares MSCI Japan Index Fund, respectively.
Another area where these two funds don't march in lock step like two samurais is in their performance. The iShares MSCI Japan Index Fund has had the best returns since 2003, with the exception of 2006, when the iShares S&P/TOPIX 150 outshone its sister fund with an 8.2% vs. 5.5% return. The higher returns are reflected in the nearly $15 billion of assets that the iShares MSCI Japan Index Fund has gathered, compared with the other ETF's much smaller $370 million.
New kids on the block
Midway through 2006, Wisdom Tree came out with three Japanese-focused funds that replicate an index that uses dividend payments rather than market caps to rank stocks. The three funds are the Total Dividend Index Fund
The Total Dividend Index Fund has slightly less than 300 holdings, with an average market cap of $17.7 billion. Consumer goods are the largest sector at 26%, followed by industrials at 17%, and financial services with 12%. Toyota is by far the largest holding at nearly 8%, and large company stocks make up most of the fund.
The High-Yielding Equity Fund, like most of the other Japan ETFs, has Toyota as its largest holding, at 16% of assets. In addition, more than half of its assets are invested in its top 10 holdings, making this fund much more concentrated and less diversified than the other Japan ETFs. This fund's heavy weight in only a few stocks doesn't mean it has few options to select from, as it holds 224 stocks in its portfolio. Sector exposure is concentrated in consumer goods at 32% and utilities at nearly 19%.
The SmallCap Dividend Index Fund has the largest number of holdings of these three funds, with roughly 500 stocks. Unlike its sister funds, assets are widely diversified, and all stocks are generally less than 1% of assets. Industrial and consumer cyclicals are the top sector weights at 27% and 24%, respectively. Medium-cap companies make up 70% of investments, while small-cap companies are 30% of assets.
A yen for other options
Investors with a yen to get exposure in Japan now have a Japanese currency ETF from Rydex to consider, the Rydex Japanese Yen ETF. Since its launch in February 2007, the fund has gathered more than $360 million in assets. One of the primary reasons the fund has attracted so much interest is that it's seen as a play on the recently volatile yen. That should be a warning shot to investors that currency markets can swing wildly and the fund could experience significant variations in returns.
It isn't clear where the yen may be going, but if it strengthens, that could hurt the Japanese equity markets. A higher yen translates into higher prices for Japanese exporters and results in these exports being less competitive. For a market as dependent upon exports as Japan is, this could seriously affect the returns of a yen ETF.
With all the hype about the China tiger, it's easy to forget that Japan is the world's second-largest economy and stock market. Investors have needed the patience of someone at a Japanese tea ceremony to get through all the problems that have stalled this market. After years of interest rates at next to nothing, the economy isn't completely healthy. This is due in part to weak consumer spending, which reduces domestic demand. Japan also has an aging population, which affects the ability of its companies to recruit younger workers.
Exports have been a key component of Japan's strong economic growth, and the expansion of markets in the Pacific Basin is good news for many Japanese companies since they have ties in the emerging economies of Asia. Japan is one of the few countries in the world to have a trade surplus with China and has been able to hold on to its industrial base. This foundation, combined with low interest rates, helps keep corporate profits high. Another positive is that Japan's savings rates are beginning to drop into mid-single digits, which means consumers have more confidence and are willing to spend now rather than save for later.
In 2006, the Japanese market had a return of less than 5%, which is not very exciting, but this underperformance could be positive for returns going forward. Japan has a solid economic base to benefit from the growth of its own and neighbor's economies. Those investors who decide to take the plunge into Japan should keep their investment to a small part of a diversified portfolio.
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Fool contributor Zoe Van Schyndel lives in Miami and enjoys the sunshine and variety of the Magic City. She does not own any of the funds or securities mentioned in this article. The Motley Fool has a disclosure policy.