Got a Yen for Japan?

One exchange-traded fund gives investors ample exposure to a currency some believe is undervalued.
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Feeling bullish on Japan? ETFs can help.

Investors betting against the dollar have been burned this year by the greenback's rise. Even so, some fund managers say the Japanese currency has reached bargain levels, making it a good time to look at Japanese stocks and the yen.

One way to do that would be to buy a Japan-based open-end mutual fund that doesn't hedge currency exposure. Unfortunately, actively managed international funds tend to be pricey, with expenses that can cost close to 2% of assets per year.

A far cheaper way to play a possible yen rebound would be to buy the

iShares MSCI Japan

(EWJ) - Get Report

exchange-traded fund.

The EWJ tracks the MSCI Japan index by holding 284 Japanese stocks. It offers a comparatively low expense ratio of 0.59%.

The EWJ ranks as one of the top 10 ETFs in terms of net assets, with close to $7 billion. That puts it roughly on par with the

Diamonds Trust

(DIA) - Get Report

ETF, which tracks the 30 stocks held in the widely watched

Dow Jones Industrial Average

. Sizewise, the

S&P SPDR

(SPY) - Get Report

tops the list at $51 billion.

The EWJ is also among the leaders when it comes to volume. Over the past three months, the EWJ's average daily volume has risen to just over 8 million shares per day, once again putting it in the top 10 for all ETFs -- though not in the class of the

Nasdaq 100 Trust

(QQQQ)

, or QQQQ, which leads all ETFs by trading over 100 million shares a day.

In terms of performance, the EWJ is down a painful 9.1% year to date. That includes 4.3 points worth of currency losses, as the yen has moved above 107 to the dollar from 103 in January.

Should the yen strengthen or the dollar stumble, the unhedged EWJ would thrive. Of course, as Lisa Chen, portfolio manager for the Barclay's Global Investors, the company behind the iShares brand, reminds us, the EWJ is not simply a pure play on the Japanese currency.

"You get exposure to the yen because the EWJ is unhedged, but you need to be bullish on domestic recovery and the underlying stocks as well," says Chen.

A Yen for Yen

Market watchers have attributed a variety of reasons for the yen's struggle against the dollar, ranging from political tensions with longtime nemesis-turned-trading-partner China to renewed fears of a Japanese economic slowdown to simply an oversold bounce for the greenback.

Looking at the longer-term picture, however, the yen is still 10% stronger than it was two years ago, when it was hovering near 120 per dollar. And many fund managers, including

Pimco global bond fund manager Sudi Mariappa, say the trend is still in favor of a stronger yen, mostly due to improvements in the underlying Japanese economy.

"Japan's X factor is that domestic conditions are in the best shape in over a decade. Bank and corporate balance sheets are healthier. The accounting nonsense from the past is now much more transparent. There is job growth but wage growth is weak, which makes it tough to forecast inflationary pressure," says Mariappa. "In that environment, we expect the Bank of Japan to remain accommodative, and we think that the yen is likely to strengthen."

Arthur Steinmetz, portfolio manager for the Oppenheimer International Bond, agrees with Mariappa's long yen position, saying that the dollar has reached the point of being undervalued against the euro but "Asian currencies still look attractive."

"An end to zero rates in Japan and the end of the Chinese currency pegs are events that loom in the future that will provide the next leg of dollar weakness against Asian currencies," says Steinmetz. "Change can only occur in one direction in these situations: Japanese rates can't go lower than zero and the Chinese yuan can't get more fixed to the dollar than totally fixed. It may be a couple years from now, but they will occur."

Furthermore, Steinmetz says that current weakness in the Japanese economy will be "short-lived" due to the increase in regional activity, although he is not predicting an out-and-out boom either. Last week, the International Monetary Fund predicted economic growth of only 0.8% in Japan this year -- a big slowdown from the 2.6% increase registered in 2004. The IMF predicts Japan's economy will expand by 1.9% in 2006.

Big-Footing

Single-country ETFs can pose a puzzle for investors, because they are often dominated by just a handful of stocks. The

iShares MSCI Mexico

(EWW) - Get Report

ETF, for example, could easily be considered more of a Latin telecom fund than a single country ETF. The EWW holds close to a quarter of its assets in Latin American telecom giant

America Movil

(AMX) - Get Report

and nearly another 15% in

Telefonos de Mexico

(TMX)

.

The Japanese market is large and diverse enough to avoid that pitfall, and that shows through in the EWJ. The EWJ's largest holding is automaker

Toyota

(TM) - Get Report

, at 6% of the portfolio. The top 10 names held in the fund -- which include globally recognized brands like

Sony

(SNE) - Get Report

and

Canon

(CAJ) - Get Report

-- account for less than 25% of total assets.

When it comes to tracking its benchmark, Morningstar analyst Dan Culloton says the EWJ has done a decent job, but it has its risks.

"Its shares have been known to trade at discounts and premiums of more than 1% to its net-asset value for short periods, which means buying at the latter and selling at the former can hurt returns," says Culloton.

Culloton's big concern is with the volatility of its returns, an understandable problem considering the difficulties fund managers have had in forecasting Japan's stop-and-go economy. Many fund managers, for instance, were underweight Japan in their global allocations in the 1980s when the country was dominant, and overweight in the 1990s when its economy was dismal.

"The EWJ has always been a popular fund, due to the inability of portfolio managers to get Japan right," says BGI's Chen.