Maybe The Right Japan ETF Right Now

Last week, Japan joined the ranks of countries with negative interest rates, pounding the yen and providing a boost to currency hedged Japan exchange-traded funds in the process.

Investors looking for alternatives to U.S. small-caps while continuing to stick with developed markets should look to a familiar destination: Japan. Though some well-known exchange-traded funds tracking Japanese small-caps have posted negative returns in recent months, these ETFs have been notably better than both U.S. equivalents and Japanese large-cap ETFs.

With the combination of Japan's ongoing monetary easing efforts and ex-U.S. developed market small-cap ETFs looking somewhat appealing, the current environment could be constructive for ETFs such as the WisdomTree Japan Hedged SmallCap Equity Fund (WisdomTree Trust) DXJS), the small-cap answer to the popular WisdomTree Japan Hedged Equity Fund DXJ.

Related Link: Japan's Surprise Rate Move Lifts Stocks

Looking Into DXJS

The $166.2 million DXJS is up 7 percent over the past year, making it one of the better-performing WisdomTree ETFs over that period.

“Interestingly, owning Japanese small caps with exposure to the yen generated the lowest volatility of any of the strategies on this list. With the Japanese yen ending the year virtually unchanged against the U.S. dollar, it comes as no surprise that both the hedged and the unhedged version of WisdomTree’s Japanese small-cap strategy made it on our top five list for 2015.

“Small-company performance in Japan, as well as small-cap performance across Europe, is yet another reminder that U.S. investors should look to international small caps if they wish to fully tap the power of the so-called 'size factor,'” said WisdomTree Chief Investment Strategist Luciano Siracusano III in a recent note.

DXJS is levered to the weak yen at the sector level in addition to its currency hedged kicker. The ETF allocates nearly 49 percent of its combined weight to consumer discretionary and industrial stocks.

On the surface, many investors might criticize the lack of inflation, weak macro data and Japan’s corporate exposure to emerging markets as good reasons why Japan’s equity market should have played catch up. However, investors are ignoring a really significant divorce between Japanese earnings revisions and a number of macro indicators.

Japanese Earnings Revisions, Macro Indicators

"We believe Japan is likely to remain a focal point for investors in 2016. The Bank of Japan (BOJ) added to its already aggressive monetary easing program in January. This recent action should also keep currency-hedging strategies in focus as the divergent monetary policies between the BOJ and the U.S. Federal Reserve are likely to put renewed pressure on the yen,” added Siracusano.

Last year, DXJS' underlying index returned almost 18 percent with a standard deviation of 13.3 percent and a Sharpe ratio of 1.31, according to issuer data.

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