4 Small-Cap ETFs For A Bumpy Japan Ride

Japan has been on an uneven recovery path with wild fluctuations seen in recent quarters. This is especially true as the country lost its momentum yet again, snapping two quarters of expansion.

The economy contracted 1.6% year over year in the second quarter compared to a solid 4.5% growth in the first quarter. However, this is slightly better than the market expectation of a 1.8% decline. A drop in consumer spending, weak exports and lower private consumption continued to weigh on the growth of the world's third-largest economy. The slump in Japan’s biggest trading partner – China – added to the woes (read:China Currency Devaluation is Awful News for These ETFs).

The slowdown seems to be a major setback for Prime Minister Shinzo Abe and his reform policy – Abenomics – which is aimed at pulling the country out of two decades of deflationary pressure and returning to growth.

More Stimulus in the Cards?

Sluggish growth has raised speculations of additional monetary and fiscal stimulus by the central bank later in the year to boost growth. Earlier this month, Bank of Japan (BoJ) announced that it is seeking expansion in its massive asset purchase at 80 trillion yen per year if lower oil prices continue to hold back inflation at a near zero level. The bank recently cut its annual growth outlook to 1.7% from 2% and inflation to 0.7% from 0.8% for this year.

However, many economists believe that the slowdown in the second quarter was because of temporary factors, mainly the China turmoil, and that the Japanese economy will return to growth in the ongoing quarter. According to Capital Economics, Japan will return to a modest growth in the third quarter and see 1% growth for the full year. Further, as per the survey by the Japan Center for Economic Research, 40 analysts project that growth would rebound by an average 2.5% in the third quarter.

The could be easily depicted in the solid manufacturing PMI data, which showed that business activity expanded in July with broad-based improvement in output, new orders, employment and exports. Notably, the PMI index climbed to 51.2 in July from 50.1 in June. Exports recovered in July on cheap yen. This is because Japan is primarily an export-oriented economy and a weaker currency makes its exports more competitive. Rise in exports and hopes of further stimulus measures would boost the stock prices in the coming months (read: 3 Top Japan ETFs to Surge Higher in 2H).

While the rally will likely take place across various market spectrums, small caps will benefit the most, as these are less vulnerable to China’s uncertainty or any other external threat. Below, we take a look at four ETFs, which track the small cap segment of the Japanese stock market. All of these funds offer access to pint-sized securities in the nation. These are likely to see higher volatility yet deliver better returns if the Japanese economy trends in the right direction.

WisdomTree Japan SmallCap Dividend Fund ((DFJ ETF report))

This fund targets the dividend paying small cap stocks by tracking the WisdomTree Japan SmallCap Dividend Index. Holding 598 securities in its basket, it has a spread out exposure to various components as each firm holds less than 0.9% of total assets. From a sector look, industrials and consumer discretionary take the top two spots with one-fourth share each, while materials, financials and information technology round off the next three with double-digit allocation each. The product has amassed $335 million in its asset base while trades in a lower volume of under 36,000 shares. It charges an annual fee of 58 bps and has gained about 2.4% over the past three months. The fund has a Zacks ETF Rank of 2 or ‘Buy’ rating with a Medium risk outlook.

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