Analyse: CS ETF (IE) on MSCI Japan Large Cap

The CS ETF (IE) on MSCI Japan Large Cap provides equity exposure to one of the biggest economies on the globe and could therefore be considered for use as a core component of a well diversified portfolio to gain exposure to the world’s third-largest economy. However, before considering an investment in this ETF--either as core building block or a tactical tool--investors should be aware of existing exposure to Japan through other holdings (for example, Japanese equities comprise nearly 10% of the MSCI World Index) to avoid unintentionally overweighting Japanese shares.

Taking a close look at the track record of the Japanese stock market over the last 20 years, one might wonder whether owning Japanese equities as part of a buy-and-hold strategy would be of any benefit. The MSCI Japan Index lost about 30% of its value over that period, compared to a 230% increase in the MSCI World Index. After the Japanese real estate and stock market meltdown in the 1990s, the Central Bank hesitated to intervene. By the time the Central Bank made a concentrated effort to stimulate the economy, flooding the market with trillions of yen and decreasing interest rates, the economy was already in a deflationary spiral and consumers had lost faith. Low interest rates from there on made the Yen an attractive target for carry traders, helping to strengthen the currency and ultimately hurting exports.

Japan’s stock market had its strongest start to the year since 1988, surging 20% in Q1 2012. Exporters, the key driver of the economy, benefited from a brief correction of the Yen versus the USD, perceived cheap valuations and improving economic prospects. However, as the European debt crisis regained momentum during Q2 2012, the Japanese stock market gave up more than half of its recent gains. As the latest economic data indicate, Japan is still battling with the aftermath of the 2011 earthquake and suffering from the weak global economic outlook.

In May, Japan posted a trade deficit of $11.5bn, its third straight monthly shortfall. The deficit grew by 5.4% m/m and was double what market participants had expected. The deficit was mainly driven by the country’s first-ever trade shortfall with Europe and a surging energy import bill. As Japan’s nuclear power plants are still shut down, the country depends heavily on energy imports. More than half of May’s import increase was attributable to natural gas and crude oil. Imports of liquefied-natural gas skyrocketed by almost 50%. Also, it is expected that any benefit from the recent decline in oil prices will be more than offset by increasing import volumes going forward. Although some nuclear power plants will come back online, it is expected that there will be a permanent mix shift in the country’s power generation capacity, making it even more vulnerable to fluctuating commodity prices in the future. 

Japan’s exports rose for the third consecutive month in May, climbing by 10% y/y. This increase was driven by increased demand for automobiles and auto-parts, with exports in this category to the US jumping almost 40%. However, the export gains are largely due to the low base of comparison from a year earlier when the natural disaster wrought havoc on supply chains.  

Industrials, the largest index sector represented in the index, continues to suffer under the strong Yen. Since mid-2008, the Yen has appreciated by about 30% against the USD and by almost 70% against the Euro. In particular auto makers have struggled to compete on the basis of either price or profitability with their US, German, and South Korean rivals due to the Yen’s strength. Toyota, the largest index constituent, is affected the most as it still manufactures over 40% of its global volume in Japan. As a result, companies are increasing their efforts to move their production abroad. This could ultimately have a negative impact on Japanese employment.

However, the consumer sector, the second largest sector of the Japanese economy, has done well so far this year. In June, the BOJ stated that domestic demand and not exports was the driving force for economic growth the first time in 20 years. As weakening global demand suppressed exports, domestic demand was mainly driven by reconstruction-related activities. Public works spending was a key contributor to the 1% q/q expansion in GDP in Q1 2012.  Strong domestic demand and possible wage growth could help the country to break out of its long-running deflationary trend.

The Japanese government’s post-quake reconstruction spending and other incentives to spur economic growth will run out later this year, weighing on the country’s economic outlook. 

The MSCI Japan Large Cap (NR) Index is a price index including 70% of the largest companies (in terms of market cap and turnover), generally incorporated in Japan. Component stocks have to be listed on the Tokyo Stock Exchange, Osaka Stock Exchange, JASDAQ or the Nagoya Stock Exchange to be eligible for inclusion. Moreover, the stocks in the Index must be available to investors worldwide. This creates an Index that provides representation across 10 sectors and 151 constituents. The base currency of the MSCI Japan Large Cap is Japanese Yen. The index is calculated on a real time basis and disseminated every 60 seconds during market hours. All dividends are reinvested after deducting withholding tax by applying the maximum rate of the company’s country of incorporation applicable to institutional investors. This was 20% as of November 2010, according to MSCI. The dividends will be re-invested on the day the security is quoted ex-dividend on its principal exchange. However, in Japan, many companies declare their dividends after the ex-date, meaning an estimation of expected dividends is reinvested on that day. If no estimated dividend is declared by the company, MSCI uses the dividend from the previous year as approximation. In case of a discrepancy between the estimated and the ratified dividend, it will lead to a payment default (reinvestment without correcting past index levels) on the following business day. This can obviously lead to difficulties when tracking the index.

The CS ETF (IE) on MSCI Japan Large Cap uses the physical replication method to track its reference index. The fund intends to invest in equities and equity-related securities which relate to the components of the index. The ETF can however also invest in other securities with equity-like characteristics, like preferred stocks, warrants or convertible securities. The fund may hold up to 20% of its NAV in securities from a single issuer of equities or equity-related securities in order to track the benchmark. Under exceptional market conditions, the fund manager reserves the right to invest up to 35% of the fund’s net assets in securities from a single issuer. In addition, the ETF is also permitted to use futures on the MSCI Japan Large Cap in order to achieve its objectives. Depending on market conditions and/or the relevant weight of the index member, the fund manager can also decide to use an optimised sampling method rather than full replication. As of this writing the fund currently employs full replication; investing in all 150 index components. In addition, the fund can also utilise swaps (funded, unfunded, total return, relative performance or outperformance swaps) to gain indirect exposure to the Index. The fund manager is moreover permitted to invest in a portfolio of transferable securities or other eligible assets that comprises all the Index members, an optimised sample thereof or unrelated transferable securities or other eligible assets. This could include equity and equity-related securities, fixed income, asset-backed securities, FDIs and/or units of other open-ended collective investment schemes. If the fund, by using the above mentioned means of investment, does not fully replicate the index on an aggregated basis, the manager enters into swap agreements and/or other FDIs. The Fund does not intend to declare any dividends; however, it retains the right to pay a dividend for all share classes. If any dividends are paid, the NAV would be reduced accordingly. 

The fund levies a total expense ratio of 0.48%. This lies in the middle of the range for ETFs tracking Japanese equities.

As of this writing, there are quite a few ETFs on the market giving exposure to Japanese large cap equities; 22 to be precise. The majority of the funds however are tracking the MSCI Japan Index which includes large and mid cap names rather than strictly large cap ones. There are also a few ETFs available in US Dollar- or EUR-denominated versions. But to stay within the investment theme above (Large Cap, well diversified, Base Currency Yen) there is only one like-for-like alternative covering the same Index which is the ETFlab MSCI Japan LC. The ETFlab product is just a fifth of the size of the CS offering. Furthermore, very low trading volume in the ETFlab product is concerning, as there have been some days where there has not been a single recorded on exchange trade in this fund’s shares. It is worth noting however that the ETFlab product distributes dividends--yielding 2.3% as of this writing--whereas the CS fund does not.