What Is a Japan ETF?

The term Japan ETF refers to an exchange-traded fund (ETF) that invests the majority of its assets in Japanese equities trading on local stock exchanges. Like other ETFs, Japan ETFs are diversified investments that have a low initial investment requirement and lower costs. Investors can find eight major indices tracked by ETFs on Japan's stock market. This is in addition to those that track small- and mid-cap investment strategies and currencies. Japan ETFs give investors access to the Japanese economy through currency, equity, and fixed-income markets.

Key Takeaways

  • A Japan ETF is an exchange-traded fund that invests in Japanese equities trading on local stock exchanges.
  • Japan is home to a number of major indices tracked by ETFs, as well as others that track small- and mid-cap equity strategies and currencies.
  • Investors can gain access to the Japanese market and economy by purchasing shares of ETFs rather than stocks or other securities.

How Japan ETFs Work

Investing in foreign stock markets was something only sophisticated traders could hope to achieve in the past. But average investors have steadily been able to get a piece of the action, giving them the chance to profit from the global shifts in capital. This movement of money has a lot to do with the advance of ETFs.

ETFs pool assets from investors who have similar goals. These funds are listed on exchanges and trade throughout the day just like ordinary stocks. They strive to replicate the performance of a broad equity market, specific sector, or trend by mirroring the holdings of a designated index. This is a hypothetical portfolio of securities representing a particular market or a segment of it.

Japan is an advanced economy with a large equity market. That means there are plenty of ETFs to choose from, including more exotic ones that focus exclusively on the country’s smaller, up-and-coming companies, dividends, or value stocks. As with several of the larger, more liquid ETFs, some Japan ETFs can be sold short and are even accessible through listed options.

Japan ETFs, like other international ETFs, provide U.S. investors with an easy way to gain exposure to the country without needing to directly buy its stocks and place all their eggs into one basket. These vehicles are managed passively around a broad underlying index, such as the MSCI Japan Index, whose 301 constituents cover approximately 85% of the free float-adjusted market capitalization in the country.

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An Introduction To Exchange-Traded Funds (ETFs)

Special Considerations

Plenty of investors underestimate the effects that currency fluctuations can have on total returns. If the U.S. dollar rises in value against the Japanese yen, then an unhedged ETF will suffer currency losses that can offset any gains in the underlying Japanese stock market.

During periods of dollar strength, many investors found currency risk undesirable, paving the way for a rise in a category of ETFs that hedge out currency risk. Their goal is to give investors a return closer to the local-currency returns of a country’s major stock market indexes.

Japan ETF performance doesn't correlate to the performance of the underlying index when measured in U.S. dollars. It's the exchange rate change between the yen and the dollar that must be taken into consideration. 

Benefits of Japan ETFs

The Japan Exchange Group, which owns the Tokyo Stock Exchange (TSE), is the largest and most progressive stock exchange in Asia Pacific by market cap. This makes the country a frequent source of investor focus and attention. Japan ETFs allow for a single diversified investment in the country, while also making a bet on the strength of the yen versus the dollar.

Japan has popped back onto investors' radars ever since Prime Minister Shinzo Abe first took office in 2012. Abe steadily introduced a series of shareholder-friendly reforms, encouraging Japan Inc. to stop hoarding cash and start increasing dividends and stock repurchases. He also targeted negative interest rates, a controversial policy designed to stimulate spending and depreciate the yen. Since Japanese companies are big exporters, a devalued currency gives them a competitive edge.

Though widely talked about, Abenomics hasn’t been an overnight success. These economic policies have, however, made Japan a hot topic in investment circles and shone the light on it being home to some of the best companies and brands in the world.

Criticism of Japan ETFs

Abenomics has failed to reenergize the Japanese economy as much as first hoped. The country has a fair number of issues, including decades of deflation, an aging population, and high levels of debt.

Japan's market is also more limited than the U.S. ETF market, both in size and variety. This difference could be attributable to the fee structure for the Asian market in general. In the U.S., the trend has been toward a fee-only fiduciary model for many investments. In Asia, on the other hand, many investment products continue to be sold by agents on commission.

Example of a Japan ETF

The iShares MSCI Japan ETF (EWJ) is perhaps the best-known ETF in this category. The fund aims to produce investment results that correspond to the MSCI Japan Index using a market capitalization-weighted method. In other words, a company’s representation is based on its size.

iShares’ Japan ETF and the MSCI Japan Index are pretty much identical, ensuring little tracking error. Both have 301 holdings, led by Toyota (TM), which accounts for roughly 4% of total assets, consisting mainly of industrials, consumer discretionary, financials, and technology stocks.