Japan ETFs Show the Dangers of Buying on Disasters

Japan ETFs Show the Dangers of Buying on Disasters
Japan ETFs Show the Dangers of Buying on Disasters

Days after the devastating earthquake in Japan, prominent investors such as America's Warren Buffett and Switzerland's Marc Faber pronounced themselves bullish on the country. "Something out of the blue like this, an extraordinary event, really creates a buying opportunity," Buffett said.

An investor stampede followed, with many people putting money into U.S.-based Japan exchange-traded funds. According to market researcher Trimtabs, between March 15 and March 23, nearly $1.7 billion flowed into Japan ETFs. But these investments carry more risks than the average small investor probably realized.

Those ETFs have two strikes against them: The stocks in the fund are priced in yen, but the ETFs themselves are priced in dollars, which means buyers take on a larger than normal currency risk. And because the Tokyo Stock Exchange is closed during U.S. trading hours, the ETFs often sold at a huge premium to the underlying shares -- as high as 9.25%. If that premium gap closed when the Tokyo markets reopened, buyers of the ETF shares could have taken rapid and dramatic loses.

G7 Bankers Put Pressure on Yen

As it turns out, the main Japanese ETF, ishares MSCI Japan Index (EWJ), is down only 3% year-to-date, which is much less than it fell in the immediate aftermath of the quake and tsunami.

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For one thing, the yen hit a record high of 76.25 to the dollar on March 17. Nearly $900 million flowed into the Japanese ETFs in the preceding two days on the expectation that companies would sell foreign holdings and bring the proceeds back to Japan to buy yen.

But then, in the first coordinated intervention in a decade, the central banks of the G7 nations took action in the currency markets to force down the value of the yen – an extraordinary move. It now stands about 80.95 to the dollar, a decline of 5.1% in a week.

"I'm sure a lot of people who were doing this trade were unaware that the yen was at the highest level since 1996," says Michael Krause, president of AltaVista Research in New York, which produces the website etfresearchcenter.com. "That was a very strong risk."

Overpaying for a Stock Basket

The other risk was the so-called premium. Most ETFs are basically baskets of stocks designed to track an index. But the stocks in these ETF and their underlying indexes are in Japan, and the U.S. and Japanese markets aren't open at the same time, the share prices of the ETFs in America are moving when the closing prices of the underlying shares in Japan are a day old.

Those situations can create either premiums or discounts: In the case of Japan ETFs, premiums reached a mind-bending high last week, when funds were selling at a large markup above the value of the underlying stocks. Ishares MSCI Japan Index had a premium of 7.87% and WisdomTree Japan SmallCap Dividend Fund (DFJ) carried a 9.25% premium.

"That was extreme -- you're usually not going to have to pay that kind of spread," says Russell Wild, a financial adviser in Alllentown, Pa., who wrote Exchange-Traded Funds for Dummies."When there is a lot of confusion in the markets, such as after an earthquake, and there is a lot of movement in the markets, you risk buying at a premium."

For the small investor, it can be difficult to gauge all the risk involved. (DailyFinance makes it fairly easy to determine the premium on an ETF. On the DailyFinance homepage, enter the ETF ticker symbol followed by .iv into the "search" field, and it will show you the ETF's net asset value.)

Gambling -- and Losing -- on Egypt ETFs

"It's always better to get a broader, more diversified portfolio so that you are not locked into one thing," says Lawrence Carrel, author of ETFs for the Long Run. "The more narrowly focused you are, the more potential there is that anything that happens in that one particular market is going to lose you a significant amount of money."

Krause says that as a rule, regional funds tend to be less volatile than single-country funds because risk is spread over a larger area and number of currencies. But some single-country funds, such as those based on the British markets, have less volatility than emerging market regional funds.

Another example of the inherent risks of ETF investing overseas is illustrated by what happened to the main Egypt ETF, the Market Vectors Egypt Index (EGPT). Some market observers had also called Egypt was a buying opportunity because its shares had been driven down by street demonstrations against President Hosni Mubarak, who eventually agreed to step down.

Trading in the EGPT was brisk in the U.S., and the ETF moved consistently higher even though the stock market in Egypt was closed for more than a month. When the Egyptian Exchange reopened on Tuesday, stocks dropped 10% and EGPT opened at $15.86, a decline of 17% from its March 9 high.

As Wild notes, money committed to these markets often has to be reclassified from an investment to a speculation. It's fine if you have some part of your portfolio set aside to make such wagers, but they aren't something you should risk your savings on.

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