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By Patricia Oey

While the Nikkei 225 has returned almost 20% year-to-date, the largest Japan equity ETF, iShares MSCI Japan Index (NYSEARCA:EWJ), has returned less than 10%. EWJ, like most foreign equity ETFs, does not hedge its foreign currency exposure. As such, this ETF's returns reflect both the performance of its underlying index, as well as changes in yen/dollar exchange rate. Over the last few years, investors in EWJ have benefited from the steadily appreciating yen against the U.S. dollar. But after the Bank of Japan boosted its asset purchase program and set an inflation target of 1% last month, the yen began to fall. This falling yen is now providing a tailwind for Japan's large-caps, many of which are major exporters, and has helped drive a rally in Japanese stocks.

In such an environment, it makes sense to invest in an ETF that hedges its foreign currency exposure, such as WisdomTree Japan Hedged Equity (NYSEARCA:DXJ). DXJ tracks a dividend-weighted index, so while it won't provide the performance of the Nikkei, it should outperform an unhedged fund such as EWJ when the yen is falling against the dollar. In addition, this ETF has a slight value tilt. Historical data have shown that the value premium, the tendency for value stocks to provide greater risk-adjusted returns relative to growth stocks over the long term, also exists in Japan. However, investors should note that value strategies can underperform for periods of time.

Fundamental View
Japanese stocks have been trading around book value for a number of years, despite the fact that many Japanese companies are global leaders in autos, electronic goods, and machinery manufacturing. And after more than a decade of deleveraging, corporate Japan's balance sheet is in excellent shape. However, since the 2008 global financial crisis, Japanese companies faced a number of headwinds: a sluggish domestic economy, deflation, slowing global growth and a rising yen. From January 2007 to December 2011, the yen rose more than 50% against the U.S. dollar. These factors weighed heavily on a stock market tilted toward cyclical stocks.

The near-term outlook for corporate Japan might finally be improving. Aside from the falling yen, other positive trends include an improving U.S. economy, relatively healthy Asian economies (a growing major export destination for Japanese products), and post-quake-related spending. These factors should support significantly better earnings in the next fiscal year (which ends March 2013). And since the devastating 2011 earthquake and tsunami, corporate Japan has been much more proactive in diversifying its supply chain and investing in overseas manufacturing capacity, which should be beneficial over the long term. These efforts should also better position Japanese companies in the faster-growing emerging markets.

As for risks, power supply could be an issue this year as most nuclear power plants remain offline, and as spring temperatures are predicted to be higher than normal. If oil prices continue to rise, it will negatively affect Japan, as well as global growth. More broadly, Japanese companies face stiff competition from Korean and Taiwanese companies, as well as from their developed-markets peers. And over the longer term, it will be very challenging for Japan's relatively weak federal government to address the country's high public debt levels, sluggish domestic growth outlook (due to its aging population), and rising entitlements, all of which could have an impact on Japan's financial stability.

Portfolio Construction
This fund employs representative sampling to track the WisdomTree Japan Hedged Equity Index, a fundamentally weighted index that measures the performance of dividend-paying companies incorporated in Japan and listed on the Tokyo Stock Exchange. The 800 companies that comprise the index are weighed based on annual cash dividends paid. The index is reconstituted annually.

This fund's largest sector allocations are industrials (which include steel and chemical companies), financials, and consumer discretionary (which includes automobiles and consumer electronics companies), accounting for 18%, 18%, and 15% of the portfolio, respectively.

Relative to the Japan benchmark Nikkei 225 (which is a price-weighted index), this ETF has heavier weightings in utilities and financials and lower weightings in technology and industrial companies.

This ETF hedges its Japanese yen exposure by holding currency forward and futures contracts.

Fees
International ETFs tend to have higher expenses, relative to domestic ETFs. We think DXJ's expense ratio of 0.48% is reasonable.

Alternatives
The most popular and liquid ETF for Japanese equity exposure is iShares MSCI Japan Index (EWJ), which charges 0.51%. This ETF does not hedge its foreign-currency exposure.

There is one ETF that tracks the Nikkei 225-- Maxis Nikkei 225 Index (NYSEARCA:NKY)--but this ETF does not hedge its foreign currency exposure. Its expense ratio is 0.50%.

Disclosure: Morningstar licenses its indexes to certain ETF and ETN providers, including BlackRock, Invesco, Merrill Lynch, Northern Trust, and Scottrade for use in exchange-traded funds and notes. These ETFs and ETNs are not sponsored, issued, or sold by Morningstar. Morningstar does not make any representation regarding the advisability of investing in ETFs or ETNs that are based on Morningstar indexes.

Source: Watch for Currency Effects On Japan ETFs