The newest Japan ETF to hit the market, the PowerShares FTSE RAFI Japan ETF, is different from the rest of the ETF options focused on the land of the rising sun. What makes this fund unusual is that it follows an index designed using fundamental factors, as opposed to the market-cap weighted approach that most ETFs use. This change is supposed to provide more exposure to stocks that will outperform their peers, leading to better performance than with traditional cap-weighted indexes.
Weighing the fundamentals
The index that the PowerShares Japan fund tracks, the FTSE RAFI Japan Index, looks at much more than just the size of its constituent companies. It also looks at four other fundamental measures of size: sales, cash flow, book value, and dividends.
When you apply these measures to Japanese stocks, you end up with heavy concentrations in a few sectors. The fund has 22% of its assets in consumer discretionary stocks, followed by industrials (21%) and information technology (13%). The fund's top holdings include Toyota
Japan has been slow to recover from a long bear market, but things have started to pick up. The Nikkei 225 stock average recently hit a seven-year high. The Japanese stock market has finally come to life based upon solid economic data and strong corporate results, along with growth in business fixed investments and increased exports. At the same time, unemployment has fallen below 4% and household income has continued to rise, boding well for domestic demand.
These factors are all signs the stock market in Japan is benefiting from an array of good news that has been missing in past years. If that continues, there may be room on the upside for returns.
Fundamental vs. cap-weighting
You can expect to see many ETFs start using alternate methods similar to what the PowerShares Japan fund is using to come up with index weightings. In general, the argument against capitalization weighting is that stock prices can be influenced by factors such as speculation, insider buying, or momentum traders. These factors can result in a stock being overpriced compared to its fair value, which means an index based upon price would end up with an overweighted position in those stocks. At the same time, stocks that are underpriced to their fair value would be underweighted in the index. In general, that's exactly what you don't want for your portfolio.
By using different weights, fundamental indexing can end up favoring value stocks and companies with smaller capitalizations, two sectors which have been on a roll over the past few years. On the downside, fundamentally indexed funds will have much higher portfolio turnover than typical index funds, leading to higher expense ratios. But if the performance advantage outweighs these negatives, such ETFs are likely to get popular in a hurry.
Although the jury is still out on fundamental weighting, it may take years to gather sufficient performance data to make a definitive conclusion. Fundamental weighting is a relative newcomer to the indexing world. That may be a point in its favor -- since what is new in the market can sometimes work well until it becomes the norm.
With its low correlation to the U.S. market, Japan provides significant diversification benefits for investors. But with its relatively high 0.75% expense ratio and its untested indexing strategy, the PowerShares Japan fund may not be for everyone.
With numerous Japan ETF options, you don't have to buy into the PowerShares Japan fund just to get exposure to this market. However, fundamental weighting does have some intuitively appealing arguments going for it. If you're looking for a fund with a different twist on the indexing theme, this one might be worth a try.
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.