Putting a damper on Japan’s recovering economy, the electronics export industry is slowing. Japan exchange traded fund investors may want to consider small-cap options to better focus on the growing domestic market.

The iShares MSCI Japan ETF (NYSEArca: EWJ), which includes a 52.8% weight toward mega-caps and 39.0% toward large-caps, has declined 0.9% year-to-date. [Japan Small-Cap ETFs Shine as Large Exporters Face Stronger Yen]

In contrast, small-cap Japanese stocks have been outperforming as they benefit from an expanding local economy. Year-to-date, the WisdomTree Japan SmallCap Dividend Fund (NYSEArca: DFJ) is up 5.7%, iShares MSCI Japan Small-Cap ETF (NYSEArca: SCJ) rose 5.4% and SPDR Russell/Nomura Small Cap Japan ETF (NYSEArca: JSC) increased 4.5%. Additionally, the WisdomTree Japan Hedged Small Cap Fund (NasdaqGM: DXJS), which hedges against an appreciating yen currency, is 6.6% higher so far this year.

Electronics companies like JVC Kenwood Corp. have experienced declining export revenues, weighing on Japan’s electrical machinery business, which generated trade surpluses of 7 trillion yen, or $67 billion until 2007 and could fall to a deficit as soon as next year, Bloomberg reports.

“This is a critical problem for Japan because these companies have been a driving force in the economy,” Tomoko Takase, a research manager at the Japan Electronics & Information Technology Industries Association, said in the article. “The hollowing out of the industry has been in the news but the level of awareness doesn’t match the significance of the consequences.”

The association calculates that domestic output from electronics could fall to 11.8 trillion yen this year, or less than half its 1997 peak.

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