Eyeing The Differences Between Two Big Japan ETFs

The WisdomTree Japan Hedged Equity Fund (DXJ) and the iShares MSCI Japan ETF (EWJ) are two of this year's most prolific asset-gathering ETFs.

Overall Japan ETFs raked in $2 billion last month, bringing the year-to-date total to $28 billion, according to BlackRock data.

DXJ and EWJ have accounted for over half the inflows to Japan ETFs, combining for nearly $14.5 billion worth of inflows, placing the funds second and third, respectively, behind the the SPDR S&P 500 (SPY) in 2013 asset-gathering proficiency.

While DXJ and EWJ are both Japan ETFs, how they deliver investor returns is quite different. DXJ has risen to acclaim because, in addition to exposure to Japanese stocks, the fund also shorts the yen. That means DXJ is a "currency hedged" ETF. EWJ does not feature a USD/JPY hedge.

"A weakening yen is needed to extend the market rally, and structural reforms to labor and corporate tax are needed to make that happen," according to a new research note from S&P Capital IQ.

In a year in which investors have had few options for noticeable gains outside of the U.S., DXJ in particular has stood tall. The fund has surged 24.9 percent compared to 18.8 percent for EWJ, proving the hedged yen component is an efficacious strategy. What often gets lost in the hedged currency shuffle is another critical element to DXJ's success.

That being a screen employed by WisdomTree to ensure the ETF's 310 equity holdings derive the bulk of their revenue from outside of Japan. Still, neither ETF is impervious to the effects of a stronger yen. In the past three months, the CurrencyShares Japanese Yen Trust (FXY) is up 5.1 percent. Over the same time, DXJ is down 8.8 percent while EWJ has lost 3.3 percent.

S&P Capital IQ has Overweight ratings on both ETFs, but acknowledges a preference for EWJ should the yen continue to strengthen.

"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," said the research firm.

Conversely, a sharp turn lower in the yen would lead to more upside for DXJ. DXJ charges 0.48 percent year while EWJ's annual expense ratio is 0.5 percent.

Investors looking to participate in a Japan reflation trade with more domestic concentration can consider the newly minted WisdomTree Japan Hedged SmallCap Equity Fund ( DXJS), which debuted in late June. DXJS, the small-cap equivalent of DXJ, devotes over half its weight to discretionary and industrial names, giving investors exposure to a rebound in Japan's domestic economy. DXJS was not mentioned in the S&P note.

BY Todd Shriber, ETF Professor