Japan, The Small-Cap Way

EWJFor all its economic troubles, and there are many, Japan is still the world’s third-largest economy behind the U.S. and China. An export-driven economy, Japan is home to some of the world’s largest auto manufacturers and technology companies and despite its myriad economic woes, the Japanese economy is not only large, but also diverse and dynamic.


Despite the diversity, ETF investors have a tendency to focus on the iShares MSCI Japan Index Fund (NYSE: EWJ). The iShares MSCI Japan Index Fund is not only the biggest Japan-specific ETF, it’s also one of the largest U.S.-listed country-specific funds with almost $5.6 billion in assets under management. Given that, it’s not surprising EWJ commands most of the Japan ETF attention.


Well, don’t sleep on Japanese small-caps, an asset class that is arguably more levered to a legitimate Japanese economic recovery than the country’s large-caps would be. Should that recovery finally materialize, the unheralded SPDR Russell/Nomura Small Cap Japan ETF (NYSE: JSC) would certainly be worth a look.


Nearly six years old, JSC is home to almost $93 million in AUM. More importantly, the fund has 389 holdings, none of which account for more than 0.65% of the fund’s weight. The number of holdings alone makes JSC a well-rounded play on the Japanese economy, but the ETF’s penchant for diversity doesn’t end there. Reflecting the diversity and size of the Japanese economy, JSC gives double-digit allocations to six industry groups – industrials, consumer discretionary, financials, technology, materials and consumer staples.


Put another way, it’s unlikely an investor will find that type of sector diversity with a small-cap tracking any country other than the U.S.


Thinly traded, JSC is up 5.1% year-to-date, a performance that lags EWJ, and JSC’s chart indicates the fund may be at a critical technical juncture. It’s only 5.4% below its 52-week high, but just 9.5% above its 52-week low. JSC needs to burst through $45 on strong volume or risk a retest of the $40 area, which should it give out, would doom JSC to steeper declines.


While JSC’s sector lineup shows the ETF is largely focused on Japan’s domestic economy, the fund is also highly levered to Japanese small-cap exporters. That means JSC is vulnerable to a strong yen. The Bank of Japan has been somewhat successful recently in suppressing the yen, but the currency is viewed as a safe haven play. Should the global economy begin to deteriorate, investors would shun riskier currencies in favor of the U.S. dollar and the yen and that would not be good news for JSC.


So JSC amounts to an indirect pairs trade: Short the yen, long the ETF. The question is for how long will the yen remain weak?

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