Don't Follow Bond King Jeff Gundlach Into Japanese ETF Mistake

In his most recent investment outlook, revealed Tuesday after the close of U.S. markets, noted bond manager Jeff Gundlach reiterated his bullish view on Japanese stocks. A fine call to be sure, particularly because the yen has plunged and the Nikkei 225 has surged in the wake of Shinzo Abe being elected as Japan's new prime minister.

If November 14, about the time Abe made clear his plans to run for prime minister again (he previously held the post, but departed for health reasons), marks a bottom in Japanese stocks, then Gundlach's call for embracing the iShares MSCI Japan Index Fund (NYSE:EWJ) looks all the more stellar.

EWJ, with $5.38 billion in assets under management, is the largest and most heavily traded Japan ETF. The fund has rallied more than 11 percent since November 14, including Wednesday's one percent gain. Indeed, that performance would indicate Gundlach has been right about Japanese stocks.

Unfortunately, EWJ's 11 percent return since November 14 is downright paltry in comparison to the WisdomTree Japan Hedged Equity Fund (NYSE:DXJ). Since that date, DXJ has returned 20.1 percent.

Along the way, DXJ has seen a massive surge in inflows. In mid-November, DXJ had $516 million in AUM. That number would jump to $516 million in early December and then to $845.2 million by the middle of that month.

Indicating that a DXJ's following is not broad-based, the ETF's AUM total swelled to $1.32 billion as of January 8, 2013, according to WisdomTree data.

However, past performance is no guarantee of future returns.

EWJ is home to 312 stocks, so it does give investors broad exposure to the Japanese economy and a further equity market rally there. DXJ has few components at about 270. Again, that is a statistic that might imply EWJ is the better bet. It is not.

The marquee difference between the two ETFs, and the one that highlights the potential error any investor makes by embracing EWJ over DXJ, is that DXJ's index runs a screen that excludes companies that derive the bulk of their revenue from Japan.

Remember, the falling yen is benefiting Japanese exporters and Japan's domestic economy still faces significant headwinds in the form of unfavorable demographics and mounting deficits, just to name two factors. That is not to say EWJ does not offer ample exposure to Japanese exporters. It does. However, DXJ's efforts to exclude those firms with a dependence on Japan's domestic economy has already paid dividends for investors and that trend is likely to continue if Abe is able to force the Bank of Japan to raise its inflation target and engage in unlimited monetary easing.

To be fair, even legendary investors make mistakes with country-specific ETF. For example, several smaller Brazil ETFs have sharply outperformed the iShares MSCI Brazil Index Fund (NYSE:EWZ) since Ray Dalio's Bridgewater Associates took a stake in EWZ in the second quarter of 2012.

Of course, if the current trend with Japanese holds the rally remains in tact, Gundlach will not be "wrong" with EWJ, but investors following his trade might wish they had considered DXJ instead.

For more on Japan and ETFs, click here.