A large-cap focus limits this fund’s opportunities.

fundcoverage@morningstar.comEWJ
by Daniel Sotiroff
3/26/2019
iShares MSCI Japan

IShares MSCI Japan ETF has room for improvement. It has a limited opportunity set and its fee isn’t competitive with other index-tracking alternatives. It earns a Morningstar Analyst Rating of Neutral.

This fund tracks the large-cap-focused MSCI Japan Index. It weights its holdings by market capitalization, an approach that benefits investors by capturing the market’s consensus opinion of each stock’s value while mitigating turnover and trading costs. Markets usually get long-term prices correct, but they occasionally make mistakes. Investors can drive valuations up if they get excited about a particular area of the market, and market-cap weighting will increase the fund’s exposure to it.

This strategy doesn’t own small-cap names, which puts this fund at a disadvantage relative to its peers. Market-cap-weighting large-cap Japanese stocks emphasizes the biggest names listed in Japan, driving an acute emphasis on large-cap, multinational companies. Its average market cap weighs in at nearly twice the Morningstar Category average, indicating that many of its competitors take advantage of a wider selection pool with allocations to smaller companies. Small-cap stocks increase the opportunity set for other funds in the category. They also provide cleaner access to the Japanese economy since these firms derive most of their revenue from local business activity.

The omission of small caps has also hurt the fund’s category-relative performance. The MSCI Japan Small-Cap Index outpaced the MSCI Japan Index by 3.3 percentage points annually between January 2001 and February 2019, indicating that small caps have been a tailwind for many of the fund’s competitors. Consequently, its total returns lagged the average of its surviving peers by 1.3 percentage points annually over this period.

Low expense ratios are a major advantage that many index-tracking funds offer. However, BlackRock charges 0.47% annually for this fund, a mild advantage over the 0.82% category average. By comparison, similar low-cost index-tracking funds in the category charge only 0.09%.



Portfolio Construction

This fund effectively diversifies stock-specific risk and captures the sector composition of the Japanese market in a low turnover manner, earning a Positive Process Pillar rating. The managers use full replication to track the MSCI Japan Index. MSCI sorts companies in the Japanese stock market using their free float-adjusted market capitalization. The index targets those firms that fall into the top 85% by market capitalization, with a buffer around that threshold to mitigate unnecessary turnover. It also applies additional liquidity requirements to help make the index easier to track. The portfolio weights its final holdings by market capitalization, which promotes low turnover and reduces the associated trading costs. The index reconstitutes semiannually in May and November and makes smaller adjustments during additional quarterly reviews in February and August, such as adding recent IPOs.

Fees

BlackRock charges 0.47% annually for this fund, but this fee does not distinguish the fund within the Japan stock Morningstar category, and warrants a Neutral Price Pillar rating. The fund’s total returns lagged its target index by 35 basis points annually over the trailing three years through February 2019. The fund’s securities lending activity can help offset some of its expenses.

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