Breaking Down the Two Largest Japan ETFs

ETFs tracking Japan’s stock market were higher Tuesday while in currency markets the CurrencyShares Japanese Yen Trust (FXY) lost more than 1% following reports that Prime Minister Shinzo Abe may try to lower corporate taxes.

WisdomTree Japan Hedged Equity Fund (DXJ) and iShares MSCI Japan ETF (EWJ) are the largest ETFs that invest in Japanese equities.

S&P Capital IQ was out with a note Tuesday comparing DXJ and EWJ.

The full S&P Capital IQ note is below:

ETF fund flows and strong performance year to date indicate there is a lot of interest in Japan. Below we take a look at some of the similarities and differences between two of the most successful ETFs at gathering assets this year, the WisdomTree Japan Hedged equity Fund (DXJ 46 Overweight) and the iShares MSCI Japan ETF (EWJ 11 Overweight).

The performance of the Japanese stock market this year has been nothing short of impressive. Year to date, the Nikkei 225 is up 35%, easily outperforming the S&P 500 Index’s strong 20% return. Popular ETFs DXJ and EWJ have gains of 25% and 18% respectively. These returns and investor optimism about aggressive Bank of Japan stimulus have helped iShares and WisdomTree bring in a combined $15 billion of new assets to their two flagship Japanese products. To understand what’s driving these ETFs and what might be ahead for them, we think understanding how the yen affects them is key.

According to S&P Capital IQ global equity strategist Alec Young, Japanese markets tend to rally when the yen is weakening. This year’s rally is no exception, with the yen falling 10% year to date against the dollar. According to WisdomTree, DXJ is designed to outperform a non-hedged index when the yen is weakening, thanks to its hedging practice, and underperform a non-hedged index when the yen is strengthening against the dollar. DXJ’s outperformance of EWJ this year makes sense after taking this information into consideration. However, the Japanese rally has stalled since May, as the yen has rebounded 4% versus the dollar through August 9. During this span, DXJ has declined 10%, while EWJ has lost only 4%.

S&P Capital IQ believes that a weakening yen is needed to extend the market rally, and structural reforms to labor and corporate tax are needed to make that happen. In Young’s opinion, Japanese equities will remain range-bound over the near-term as investors await news on structural reforms. He thinks structural reform momentum is needed to reinvigorate the yen sell-off and, hence, the equity rally.

Earlier this week, the Japanese government announced that second quarter GDP growth was 2.6%, versus the 3.6% estimate reported by Bloomberg. We think this information caused the yen to drop against the dollar in foreign exchange trading. This worse-than-expected data has also led some analysts to speculate that the Bank of Japan might do more easing at the beginning of 2014, according to Bloomberg.

In addition to the top-down macro drivers, we think understanding the sector weightings of the two ETFs is also important because the sector weightings of EWJ and DXJ vary substantially and movements in the yen affect some sectors more than others. According to Young, Industrials, Information Technology and Consumer Discretionary are more sensitive to changes in the yen exchange rate, and benefit more when the yen declines versus the dollar because they rely heavily on exports. These three sectors make up 50% of EWJ’s assets and 57% of DXJ’s. In particular, EWJ has more exposure to Consumer Discretionary (22% of assets) than DXJ (19%), but less to Industrials (19% vs. 24%). Meanwhile, EWJ has representation in all 10 GICS sectors, including 8% in the more defensive, locally focused Telecom Services and Utilities sectors that DXJ has no exposure to. A look at the top-10 holdings as of June reveals that DXJ is more concentrated with 34% of assets in these positions, compared to EWJ’s 24%. Just six of the these top-10 positions were recently overlapped, though the weightings are different. For example, DXJ has a larger stake in Honda Motor.

EWJ holds 316 stocks and its median market cap is $5 billion, in contrast to DXJ’s median market cap of $2 billion across 266 holdings. DXJ is slightly cheaper, with a 0.48% expense ratio relative to EWJ’s 0.53%. Both have tight bid/ask spreads of $0.01 and trade frequently. However, EWJ’s average daily volume of nearly 40 million shares is six times that of DXJ.

While investors have flocked to both ETFs as a way to benefit from the Japanese economic recovery, these two offerings are different, which should impact their performance if the Japanese market remains range-bound, as S&P Capital IQ Equity Strategy expects. If the slide of the last three months continues, we contend that EWJ will be a better choice to invest in. EWJ’s diversified weightings and its lower dependence on export sensitive sectors should help it outperform DXJ. For those who believe a rally will happen in Japanese markets and the yen will continue to weaken versus the dollar, DXJ is well-positioned, in our opinion, to be the better performer. DXJ’s more concentrated weightings and its hedged design are likely to make it outperform EWJ. S&P Capital IQ has Overweight rankings on both ETFs due to their performance, risk and cost attributes relative to other equity ETFs.

The opinions and forecasts expressed herein are solely those of John Spence, and may not actually come to pass. Information on this site should not be used or construed as an offer to sell, a solicitation of an offer to buy, or a recommendation for any product.