3 Reasons to Buy the iShares MSCI Japan ETF

Source: Flickr user Guilhem Vellut.

If you're looking to invest in a country-specific ETF in 2015 and are willing to take some risk, the iShares MSCI Japan ETF (EWJ -0.30%) may be worth a close look. Japan's economy has exhibited a great deal of volatility lately. Following the initial growth resulting from Prime Minister Shinzo Abe's "Abenomics" policies, the country slipped unexpectedly into recession last quarter due to a sales tax hike, contracting at a rate of 1.6%.

While it's too early yet to know whether Abe's government can jump-start the world's third-largest economy and rescue it from decades of economic stagnation, equity investors seem to be voting with their yen: Since Abe regained office in December of 2012, the Nikkei 225, Japan's leading stock index, is up a total of 67%. Here are three reasons why the iShares MSCI Japan ETF may reward patient investors next year and beyond.

1. A gargantuan buyer of Japanese shares will support the market

At the end of October, Japan's "Government Pension Investment Fund," or GPIF, set new asset-allocation targets, which will require it to maintain half of its investments in equities, split equally between Japanese and foreign markets. At $1.1 trillion in holdings, the GPIF is the world's largest pension fund.

According to Bloomberg News, the GPIF will have to reallocate 9.8 trillion yen, or $86 billion, into Japanese equities to rebalance its holdings between stocks and bonds. The mandate is intended to reduce bond investments, which are mostly financed by the Japanese public, and transfer the cash into equities, thus boosting the stock market. Steady buying by the GPIF should provide some support to Japanese shares in 2015, as well as some comfort to investors.

2. A weak yen helps this export-friendly ETF

As currency watchers know, the loose monetary policy that is a pillar of Abenomics has weakened the Japanese yen considerably against the U.S. dollar. The Bank of Japan announced this fall that it would enlarge the Japanese monetary base from 60 trillion-70 trillion yen to 80 trillion yen, surprising investors and pushing the yen to a new six-year low against the dollar.

This is good news for a number of companies held by the iShares MSCI Japan ETF. The index is rife with exporters, such as Toyota Motor Corp (6.3% of the index), Honda Motor Company (1.8%), Hitachi Ltd (1.4%), Canon Inc. (1.4%), Astellas Pharmaceutical (1.2%), and Panasonic Corp (1%). Yen weakness will provide a tailwind for the earnings of these and other exporters in the index.

There's one caveat, however. The iShares MSCI Japan ETF only gets a partial benefit from a weak yen, as it's a dollar-denominated index. For this reason, it hasn't kept pace with the stellar gains of the overall Japanese stock market. But investors in this fund will see an extra pop in their returns whenever the pendulum swings back and periods of yen strengthening occur. 

3. Japanese corporations may perform better -- out of shame

In a bid to strengthen both the domestic stock market and corporate profits, Abe's government launched the JPX-Nikkei Index 400 in January of this year. As a so-called "smart beta" index, the JPX-Nikkei 400 ranks companies for inclusion using a mix of quantitative and qualitative factors, rather than relying simply on market capitalization.

The index's quantitative factors include return on equity (ROE), operating profitability, and market capitalization. Companies are also judged by the following three qualitative factors: 1) appointment of at least two outside, independent directors; 2) adoption or planned adoption of International Financial Reporting Standards; and 3) English-based disclosure of earnings.

Since its introduction, the JPX-Nikkei 400 has been widely referred to as the "shame" index. Supposedly, prominent companies that didn't make the cut will be shamed into initiating more shareholder-friendly actions like repurchasing shares, enhancing operating profits, and improving management integrity. Indeed, some Nikkei 225 members left out of the JPX list this year have already appointed outside directors and incorporated new ROE targets in their business planning. 

The JPX-Nikkei 400 will boost the iShares MSCI Japan ETF in two significant ways. First, many of the ETF's heavier-weighted stocks also belong to the JPX-Nikkei 400, including all of the corporations mentioned in the preceding section. The GPIF recently announced that as part of its mandate, it has begun purchasing constituent stocks of the JPX index. Similarly, the Bank of Japan is considering buying Japanese ETFs modeled on the JPX. 

More broadly, the emphasis on profitability, shareholder benefit, and improved corporate governance (including the important step of English-translated, IFRS-based financial reporting) will likely have the effect of spurring more foreign purchases of Japanese stocks over time -- a boon to the iShares MSCI Japan ETF.

Does an investment make sense yet?

By some measures, Japanese equities are attractively valued compared to their international counterparts. According to Yardeni Research, Japanese stocks currently trade at 14.7 times future 12-month earnings, while U.S. stocks trade at 16.5 times future earnings. As a proxy for the Japanese market, the iShares MSCI Japan ETF sports a moderately low expense ratio of 0.48% and offers a current dividend yield of 1.45%.

Ultimately, however, the Japanese economy will have to find a path to sustainable growth, and domestic corporations will have to rise to the profit and transparency challenges set by Abe's government, in order for the iShares MSCI Japan ETF to appreciate meaningfully. Those with patience and risk tolerance may want to take a stake in a positive outcome.