SCJ iShares MSCI Japan Small Cap

Japan should remain in focus in 2014, thanks to its super-accommodative financial policy intended to increase monetary base at an annual run of about 60–70 trillion yen. Commonly known as “Abenomics” – implemented more than a year ago – this policy measure has done a lot to bring Japan back into the growth path. (read: Japan ETFs: One Year After Abenomics).

The Nikkei soared more than 50% in 2013, the best yearly performance in more than 40 years for the key Japanese benchmark and the Yen declined by about 14% against the greenback. Japan is an export-oriented country and the slide in the yen provides a boost to the nation’s export making its products more competitive on an international level.

However, the stock markets began to lose some steam in the beginning of 2014 as the Yen gained about 2%. Rising concerns over the health of the U.S. economy coupled with the pace of QE taper and panic of political gridlock in some other countries led to a “safe-haven” rally in the Japanese currency (read: Volatility ETFs Skyrocket on Broad Market Weakness).

This has probably fueled talks for some more easing in the monetary stimulus. Though BOJ hasn’t opted for further monetary easing in the true sense as it has kept the base monetary target intact, last week’s announcement of the doubling of incentives aimed at goading bank lending was a ray of hope in the current slump.

Inside The Move

The Bank of Japan went for a twofold increase in its growth funding facility to 7 trillion yen ($68 billion) allowing individual banks to borrow twice at rock-bottom interest rates. BOJ has also extended the duration of the loans, making it easier for financial institutions to earn more even in an ultra-low interest rate environment.

The move clearly underscores the government’s intent to spur growth and wipe out 15 years of deflation from Japan. BOJ expects these enhancements to bolster credit growth both at business and household levels. BOJ appeared content with the present growth and inflation scenario of Japan.

Market Impact

BOJ’s dovish stance came at an opportune time when Japan stocks were sagging on stronger yen and a weaker-than-expected GDP results for 4Q13. Soon after the announcement on February 18, Yen dropped and Japan’s Topix index soared to the five-month high level and Nikkei gained about 3%.

However, the cheer was short-lived as the Nikkei 225 Stock Average slipped 2.1% on February 20, following IMF’s warning of a potential global slowdown shaping up in the near term. Weakness in China and rough recovery in Euro zone also held back market activity.

Export volumes in Japan fell 0.2% year over year in January leading to a record trade deficit, despite a weak yen. Exports rose 9.5% while imports rose 25% on muted yen and heightened demand for fossil fuels to compensate for the collapse of its nuclear power in the 2011 Fukushima crisis.

Short-term Possibilities

While growth is presently a drag in Japan, we expect a spike in domestic consumption for the upcoming month. The front-loaded surge in demand prior to the consumption tax hike in April will likely support Japan’s 1Q growth profile.

Notably, the consumption tax is set to increase to 8% from April 1 from the current level of 5%. Analysts expect the central bank to take more steps to reduce the impact of the tax rise and aid the recovery.

In such a scenario, it would be prudent to cash in on Japan’s private consumption with a very short-term view and some small-caps which are relatively less open to foreign exposure (read: Is Another Great Year Ahead for Japan ETFs?).
Investors willing to seize this short-term positive blip might consider investing in the following Japan equity ETFs. All three funds currently have Zacks Rank #3 (Hold).

WisdomTree Japan SmallCap Dividend Fund (DFJ)
For better access to the core Japanese markets, investors can look to invest in small cap securities of Japan through DFJ. This is best suited for Japan-focused investors seeking to invest in dividend paying small cap firms (read: Small Cap Japan ETFs: Overlooked Winners?).

DFJ is the most liquid small cap fund with the highest trading volume and assets under management in the small cap space. The ETF invests about $282.4 million in 554 small-cap securities. Industrials, consumer discretionary and financials enjoy top-three allocations in the fund. This industry exposure makes the fund more apt to profit from the latest loan program and the front-end loaded consumption demand.

The fund is equally weighted and does not bear concentration risk. The fund charges a fee of 58 basis points annually. While most of the Japan ETFs saw big-time losses so far this year (as of February 20), DFJ shed a marginal 2.84%.

iShares MSCI Japan Small Cap Index Fund (SCJ)

With an asset base of $131.7 million, this ETF tracks the MSCI Japan Small Cap Index which is a diversified benchmark of companies domiciled in Japan. SCJ holds over 765 securities in its portfolio with only 5.55% invested in the top 10 holdings. The product charges 48 basis points a year in fees.

In terms of sector exposure, industrials take up about 25%, while consumer discretionary and financials round out the top three with about 18% of the asset base. SCJ has lost 3.70% in the year-to-date period.

SPDR Russell/Nomura Small Cap Japan ETF (JSC)

JSC provides exposure to 464 small cap securities of Japan and manages an asset base of $80.6 million. The fund charges a fee of 55 basis points on an annual basis. Company-specific risk is not an issue for this fund. Among sector holdings, the top three are the obvious guesses, namely, industrials, consumer discretionary and financials. The fund is down 4.28% year to date.

Bottom Line

Japan’s future growth is largely dependent on the BOJ’s stimulus program, the pace of the Fed’s QE scale-back and overall global recovery. Majority of the analysts expect the BOJ to inject more stimuli by the end of September, according to a Bloomberg News survey conducted from February 6 to 12.

If this takes place and the Fed keeps axing on its stimulus, Yen will likely fall against the U.S. dollar which in turn will help Japan’s export-reliant economy. However, just falling currency will not be sufficient enough to carry on Japanese growth; the volume of exports also needs to be healthier. Amid such a volatile backdrop, it would be wise to focus on Japan’s domestic consumption,  for the time being.

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WISDMTR-JP SC D (DFJ): ETF Research Reports
 
SPDR-RN SC JAP (JSC): ETF Research Reports
 
ISHARS-MS JA SC (SCJ): ETF Research Reports
 
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