Small-Cap ETFs: An Avenue For Japan's Reflation Trade

Recent data indicate the Japanese economy is improving.

Confidence in Prime Minister Shinzo Abe's plans to weaken the the yen and spark inflation in the world's third-largest economy are among the reasons why investors have poured billions of dollars into Japan ETFs this year.

Through the end of May, year-to-date inflows to Japan ETFs were $23.1 billion, or 23 percent of all ETF inflows, according to BlackRock.

The WisdomTree Japan Hedged Equity Fund (DXJ) and the iShares MSCI Japan Index Fund (EWJ) have been the inflow leaders among Japan ETFs. However, it has been noted that those funds and some rivals do not offer large amounts of leverage to a recovery in Japan's domestic economy. With large allocations to financials and industrials, EWJ, for example, offers plenty of exposure to Japanese exporters.

Still, Abenomics was intended to jolt Japan's domestic economy. Should that effort prove successful, it could be small-cap ETFs that benefit.

"However, at its core, Abenomics is designed to stimulate economic growth in Japan—by encouraging Japanese consumers to come off the sidelines where they have sat with significant savings for a long time," said WisdomTree Research Director Jeremy Schwartz in a note.

When the yen was plunging and DXJ and EWJ were soaring earlier this year, there were certainly times when it was fair to say Japan small-cap ETFs were overlooked. Arguably, Japan small-cap ETFs are still flying under the radar although the iShares MSCI Japan Small Cap Index Fund (SCJ) is up 11 percent year-to-date while the WisdomTree Japan SmallCap Dividend Fund (DFJ) is up six percent.

Neither of those ETFs are currency-hedged as DXJ is, but both do reasonable exposure to Japan's domestic economy. Consumer discretionary and staples names combine for over 34.5 percent of DFJ's weight. Those sectors combine for 29 percent of SCJ's weight.

As investors have become infatuated with DXJ's hedged USD/JPY mechanism, it is often forgotten that the ETF's index excludes companies that depend on Japan for 80 percent or more of their revenue. With DXJ's success in mind WisdomTree earlier this year filed plans for a small-cap equivalent of DXJ. That ETF will track the WisdomTree Japan SmallCap Hedged Equity Index, which "has no such revenue screen and is meant to be broadly inclusive of Japanese small-cap dividend payers," according to Schwartz.

WisdomTree has not said if DFJ will simply switch names and indexes to become the small-cap hedged play, but that move is not out of the realm of possibility as DXJ itself changed to a currency hedged fund a few years ago. The issuer has done the same thing with with some of its other ETFs as well.

Believers in Abenomics should be believers in Japanese small-caps because, just to name a few sectors, small-cap discretionary, financial services, health care and staples depend on Japan for the bulk of their revenue.

"We believe that Abenomics will not fade quickly—on both the monetary and fiscal side, commitments have been made with a focus on long-term results and a willingness to stay the course," said Schwartz. "That points to a need for flexibility: Japan's global revenue generators might be in favor some of the time, while at other times the focus could shift more toward the more domestically sensitive firms."

BY Todd Shriber, ETF Professor