Japan equity ETFs have been largely out of favor for much of 2017, despite strong investor appetite for international stocks such as Europe, and emerging markets in search of outsized returns. The tide, however, could be about to turn.

Some of the largest Japan ETFs have all bled assets year-to-date. The iShares MSCI Japan ETF (EWJ) has seen $1.2 billion in net outflows in the first nine-plus months of the year. The WisdomTree Japan Hedged Equity Fund (DXJ) has lost about $550 million in net assets, and the Xtrackers MSCI Japan Hedged Equity ETF (DBJP) has faced $645 million in net redemptions.

These funds have performed relatively well, delivering roughly half the gains of an allocation to a broad emerging market ETF such as the iShares Core MSCI Emerging Markets ETF (IEMG). (IEMG has seen more than $13 billion in net inflows year-to-date.) They are each up around 12-15% this year despite the outflows.

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Weak Dollar & Japan

One of the key factors that has been weighing on Japanese stocks is the weakness in the U.S. dollar, which has dropped more than 8% this year, and at one point it was down 12% from early-year highs.

According to Russ Koesterich, portfolio manager for BlackRock’s Global Allocation team, a weak dollar may be good news for emerging market equities, but it doesn’t typically bode well for Japanese stocks.

The dollar may be about done with its downward run, he says. In the past month alone, the dollar has climbed about 2%.

“Selling dollars has become a bit too popular, and the greenback has started to stabilize,” Koesterich said in a recent blog. “A stable or appreciating dollar would likely prove a modest headwind for EM equities and a tailwind for Japanese stocks.”

Japan A Value

Valuations are another attractive feature of the Japanese market right now—much like emerging market valuations were in late 2016 after a major sell-off. Japan stocks are trading at a deeper discount relative to world stocks than they historically average—a 42% discount to the MSCI World Index versus a 20-year average of 32%, Koesterich notes.

“Against EM stocks, Japan appears even cheaper,” he said. “Since 1995, Japan has typically traded at a 12% premium to EM equities based on P/B [price-to-book]. Today the TOPIX trades at a 23% discount to the MSCI Emerging Market Index. This represents the largest discount since the spring of 2014, a period that preceded a 50% rally in the TOPIX.”

In 2016, Japan equity funds barely finished the year in the black, with funds like EWJ and DXJ up 2% and 1%, respectively, that calendar year. Japan ETFs have delivered a bit of a roller-coaster ride since Shinzo Abe first returned to the prime minister spot in December 2012, with nonhedged and currency-hedged strategies such as EWJ and DXJ each facing periods of strong performance and losses.

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Charts courtesy of StockCharts.com

‘Understanding The Micro Story’

But the underlying story driving stock returns remains a largely positive one through the ups and downs.

“Japan faces some serious structural issues—high debt levels, aging demographics, and so on—but everyone already knows the macro headwinds. Far fewer understand the micro story,” Forstrong Global’s president and CIO Tyler Mordy told ETF.com.

“Over the past 25 years, Japanese companies faced the twin burdens of chronic deflation and an overvalued currency. What has been the result? Corporate Japan is now extremely lean and efficient,” he added. “Aggregate Japanese return on equity has been quietly trending upwards and corporate profits just hit a record high relative to GDP.”

Other key points in this micro story, as Mordy puts it, include the fact that Japanese companies have plenty of cash on hand right now—some $4 trillion—and many are involved with cutting-edge technology and innovation—these are high growth names.

‘Frontier Of Value’

What’s more, Japan equities are cheap and the Japanese yen is undervalued. “The currency is the cheapest it’s been in 32 years,” Mordy noted. That’s important, because in previous Japan bull markets, the yen was expensive, making the current upward trend more likely to last.

“Investors don’t have to pay up for this growth,” he said. “Japanese equities are priced at the frontier of value—if not over the edge—deep into bargain territory.”

There are more than $30 billion tied to 31 U.S.-listed Japan ETFs today—plenty of ETFs to choose from. The assets are heavily concentrated on the four largest funds, which together command more than $27 billion in total assets.

The largest of these funds is EWJ, with $16 billion in total assets, followed by DXJ with $8.2 billion, DBJP with $1.6 billion and the iShares Currency Hedged MSCI Japan ETF (HEWJ) with $1.1 billion.

What’s Underneath

EWJ is a market-cap-weighted portfolio of Japanese stocks covering about 85% of Japan’s investable universe. The portfolio, which costs 0.48% in expense ratio—or $48 per $10,000 invested—is led by industrials and consumer discretionary stocks.

DXJ tracks an exporter-focused, dividend-weighted index of Japanese stocks in a portfolio that hedges out currency exposure. The 403-stock portfolio has consumer discretionary names at about 26% of the overall mix.

DBJP, meanwhile, tracks a currency-hedged version of the market-cap-weighted MSCI index underlying EWJ, offering a similar mix of stocks, while hedging for currency fluctuations between the dollar and the yen. The fund carries an expense ratio of 0.45%.

HEWJ, the most expensive of the four, with an expense ratio of 0.49%, is the currency-hedged version of EWJ. The portfolio owns EWJ and overlays that allocation with forward currency contracts to neutralize its exposure to the yen.

For a complete list of Japan ETFs, check out our Japan ETF channel.

Contact Cinthia Murphy at cmurphy@etf.com

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