Among the many ex-U.S. developed markets offering investors solid alternatives to U.S. stocks this year is Japan. Just look at the iShares MSCI Japan (EWJ), which is up nearly 12 percent this year. That is well ahead of the 9.3 percent returned by the S&P 500.
Like many developed markets outside the U.S., Japan's equity market is attractively valued compared with the U.S. Additionally, the reflation trade coupled with the weak yen are seen as catalysts for Japanese stocks. The Bank of Japan (BoJ) has engaged in one of the largest, most active quantitative easing programs over the past several years in an effort to weaken the yen while stirring inflation in Japan. Japan, the world's third largest economy behind the U.S. and China, has been in a multi-decade, mostly losing battle with deflation. (See also: Japan's Strategy to Fix Its Deflation Problem.)
Investors should note that EWJ is not a currency-hedged exchange traded fund (ETF), meaning it can lag the returns of rivals that hedge yen risk against the dollar during periods of the Japanese currency being weak against its U.S. rival. "This fund does not hedge its currency exposure, so it does not provide protection from fluctuations in foreign exchange rates between the U.S. dollar and Japanese yen," said Morningstar. "This has been noticeable the past few years as the dollar has strengthened, and subsequently reduced the fund's dollar-denominated returns. Over short periods, currency fluctuations may drive dollar-denominated returns higher or lower, but should largely wash out over long stretches of time." (See also: Are Currency-Hedged ETFs a Good Idea?)
EWJ is more than 21 years old, and with $16.6 billion in assets under management, the fund is one of the oldest and largest single-country ETFs. The behemoth Japan ETF tracks the MSCI Japan Index and holds 320 stocks, a significant percentage of which are large caps. That means EWJ lacks leverage to mid- and small-cap Japanese names, many of which can take advantage of Japan's improving domestic economy and some of which are levered to the weak yen and export story. Japan accounts for a large chunk of global equity market capitalization, confirming its heavy tilt toward larger stocks.
Industrial and consumer discretionary stocks combine for over 39 percent of EWJ's weight. Those are export-heavy sectors in Japan. "Small companies have historically provided higher returns than those having larger market capitalizations," said Morningstar. "These firms also tend to be more highly leveraged to the fortunes of their domestic economies than their larger counterparts, and so may offer better diversification benefits to U.S. investors. However, they tend to have higher volatility, and the fund has been less volatile than the category average."
Japanese economic growth is improving, a theme that should benefit EWJ even with its focus on bigger companies. "The Nikkei Japan Composite PMI Output Index rose from 52.6 in April to 53.4 in May, marking the eighth successive month of expansion and the best performance since January 2014," said Markit. "Notably, the latest reading pushed the second quarter average to 53.0, up from the first quarter's mean of 52.5, and remained consistent with robust GDP growth." (See also: An International ETF Idea for Bargain Hunters.)