ETF Showdown: Settling The Japan Debate

Due to the tumbling yen, which has lead to noticeable strength in Japanese stocks over the past several months, investors are once again turning their attention to Japan ETFs.

While there are multiple ETF avenues for gaining exposure to the world's third-largest economy, some funds such as the SPDR Russell/Nomura Small Cap Japan (NYSE:JSC) and the MAXIS Nikkei 225 Index ETF (NYSE:NKY), arguably do not receive the attention they deserve.

That is a story for another day because resurgent Japanese stocks and the faltering yen have helped shine the spotlight on two Japan ETFs over the rest of the group. Those funds are the iShares MSCI Japan Index Fund (NYSE:EWJ) and the WisdomTree Japan Hedged Equity Index Fund (NYSE:DXJ).

And with at least one noted commentator espousing the virtues of EWJ over DXJ, mainly on the basis of perceived liquidity, investors looking for exposure to Japan would do well to evaluate the differences between these two ETFs before clicking the "buy" button.

Being Superficial At a superficial level, there really should be no debate between these two ETFs. Home to $5.77 billion in assets under management, EWJ wears the crown as the biggest Japan ETF.

However, DXJ is no slouch on the size front. In January alone, the ETF raked in $1.2 billion in new assets, according to Morningstar.

In early December, DXJ had just over $500 million in AUM. That number had grown to over $3.2 billion as of February 7, according to WisdomTree data.

Keeping with theme of being superficial, DXJ charges annual fees of 0.48 percent compared to 0.51 percent with EWJ. That is one issue to consider when someone says EWJ is "better." Another is pure performance. Over the past five years, two years, one year, six months, three months, one month and year-to-date, DXJ tops EWJ. Actually, over some of those time frames, "trounces" is the more applicable way of describing DXJ's out-performance of EWJ.

Ignoring The Obvious Of course, there is a reason why DXJ outperforms EWJ and why the chasm is noticeably wide in recent months (DXJ is up over 31 percent in the past 90 days while EWJ is up 12.6 percent over the same time).

The WisdomTree offering is "designed to provide exposure to equity securities in Japan, while at the same time hedging exposure to fluctuations between the value of the U.S. dollar and the Japanese yen," in the issuers words. Translation: This fund is the better bet for taking advantage of the tumbling yen because it is constructed to do just that.

Additionally, it must be noted that while Japan's equity markets suddenly look good, the domestic economy still has myriad issues to contend with. In other words, investors should look to avoid heavy exposure to companies that depend on Japan for sizable portions of their revenue. DXJ obliges by tracking an index that excludes those firms that derive 80 percent or more their revenue from Japan.

Liquidity It is easy to assume that EWJ is more liquid than DXJ based on average daily trading volume. EWJ's is over 30.3 million shares while DXJ's is "just" 1.7 million shares. But savvy investors know that volume is not the lone gauge of an ETF's liquidity.

Look at EWJ's top holdings. Then do the same with DXJ. There are plenty of similarities. Toyota (NYSE:TM), Honda (NYSE:HMC), Mitsubishi UFJ Financial Group, Canon and scores of other familiar, heavily traded (both in the U.S. and Japan) Japanese stocks are found in both funds.

In fairness to EWJ, its bid/ask spreads can be tighter than DXJ's. At this writing, EWJ's spread is a penny while DXJ's is three cents. This may seem like bad news for DXJ, but the question that needs to be addressed is will saving two cents make up for the almost 1,800 basis points by which DXJ has outperformed EWJ by over the past 90 days? No, so quibbling over the bid/ask situation here amounts to being penny wise and dollar foolish.

There is More Another issue that must be considered is tracking error, or the amount by which an ETF's returns deviate from its benchmark index. In fact, an ETF's tracking error can be more meaningful to the investors total expenses than a two-cent bid/ask differential.

In a perfect world, all ETF's would deliver returns that mirror their underlying index minus the expense ratios. However, the world is not perfect and some ETFs sport alarmingly high tracking error. That might be the reason some professional investors focus on tracking error before expense ratios when it comes to ETFs.

When it comes the ETFs at hand in this piece, EWJ's tracking error is not dreadful. Over the past three years, it has been 0.57 percent, according to iShares data, though that is slightly higher than the fund's fees.

However, DXJ has done better here as well. In 2010, DXJ outpaced its index by 0.32 percent, but lagged the index by 0.41 percent in 2011. Last year, DXJ came out on top again by 0.33 percent. Those are not huge numbers, but they do highlight one thing: If EWJ's tracking error is fair, than DXJ's is pretty darn good.

When all of the aforementioned factors are added up, the scenario under which EWJ is preferable to DXJ is hard to imagine. Frankly, it probably does not exist.

For more on ETFs, click here.