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In the days following the tragic events in Japan, indexes of Japanese stocks traded down as much as 20%, with many individual issues trading even lower. However, an investor capable of enduring near-term fluctuations may be rewarded for allocating capital to Japanese stocks, and WisdomTree's SmallCap Dividend ETF (NYSEARCA:DFJ) may be a good vehicle for such an investor.

First, let us establish several observations on historical stock market index performance in a developed market like Japan, with the U.S. as our proxy. Over time, and though more volatile, indexes of small cap stocks such as the Russell 2000 tend to out perform large cap stock indexes such as the S&P 500. Secondly, value-oriented indexes such as the Russell 2000 Value tend to out perform their growth-oriented counterparts such as the Russell 2000 Growth.

The charts below demonstrate each of these observations over the past ten years.

click to enlarge images

Intuitively, these observations make sense. Small cap stocks often have less analyst coverage and may have limited track records in their initial stages which can often result in price inefficiencies for investors to exploit. Furthermore, small companies are often purchased by larger companies at a premium to market price. On the other hand, value companies are often under valued, or at least more modestly valued relative to their net assets and cash flows while not being subject to lofty expectations of future growth, which is inherently unpredictable.

WisdomTree's fund seeks to imitate the performance of its proprietary Japan SmallCap Dividend Index, of which 97.97% represents companies with a market capitalization below $2B. Furthermore, companies are selected for inclusion based on cash dividends paid. While this does specifically identify value companies, we can assume that the fund has a value bias because growth companies are more likely to reinvest Free Cash Flow rather than distribute it to shareholders.

Fundamentally, it is important to note that Japan is an export economy and as such many Japanese companies have large bases of operation abroad. Therefore, Japan's poor demographics and the continuing nuclear disaster may not damage many companies. The sovereign debt situation may only encourage the flow of capital into equities as the Japanese government continues to expand its balance sheet in the relief/rebuilding efforts with interest rates on its bonds remaining extremely low. These conditions may drive Japanese investors to choose domestic stocks over domestic bonds.

As of April 20, 2011, the index's dividend yield is 2.60% while its price-to-book is just 0.74.

Source: WisdomTree's Japan SmallCap Dividend ETF: Hold Tight Through Near-Term Volatility