Many global investors opting to participate in the Japanese stock rally are leaning into large-caps and related ETFs.
They’ve been rewarded for that faith, as highlighted by the WisdomTree Japan Hedged Equity ETF (DXJ) returning 20.2% YTD. However, market participants shouldn’t overlook the potential potency of Japanese small-caps. Look at DXJ’s small-cap counterpart, the WisdomTree Japan Hedged SmallCap Equity Fund (DXJS).
That ETF is up 11.7% YTD, while the Russell 2000 and S&P SmallCap 600 indexes are in the red since the start of 2024. Adding to the allure of DXJS is the point that the fund has been significantly less volatile than ETFs tracking the aforementioned pair of domestic small-cap gauges.
The 2024 performance notched by DXJS isn’t a one-off. Over the past three years, the WisdomTree ETF returned 63%, thoroughly dominating the large-cap MSCI Japan Index and the Russell 2000 and S&P SmallCap 600 indexes along the way. On an annualized basis, DXJS was less volatile than all three of those indexes during that span.
Past, Future Bode Well for Japan Small-Cap ETF DXJS
Of course, experienced investors know that past performance isn’t a promise of what comes next. Fortunately, the fundamental outlook for Japanese small-caps, including DXJS member firms, is sold and supported by financial market reforms implemented in the Land of the Rising Sun.
“Unlike the large caps, the momentum has not taken off for Japan’s small to mid-caps (SMIDs). But once it does, it can offer equally attractive returns. We believe the impact of the Tokyo stock exchange (TSE) reforms will be a key trigger to unlock value in the SMIDs. There are far more of them in terms of absolute numbers of companies in the small to mid-cap space compared to large caps. A higher proportion of SMID stocks are trading below book compared to large caps,” according to Eastspring Investments.
As noted by the asset manager, Japanese small-caps have surprisingly sturdy balance sheets. Fifty-eight percent of those firms have cash on hand compared to 45% for large- and midcap counterparts. Those cash hoards are all the more appealing when measuring DXJS against some domestic small-cap ETFs. Many small-cap ETFs are loaded with shares of money-losing companies.
“Small caps’ attractive valuations, high net cash levels and share price performance disparity versus large caps are key reasons why this group will be the largest potential beneficiaries of the TSE’s initiative. Every day seems to bring new positive news on balance sheet related reform for these companies,” added Eastspring.
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