Japan ETF Major Quake: What Should be Considered When Investing in International Market ETFs?

It's a fact that the Japanese stock market has been on a continuous rise since the beginning of the year. As of yesterday, the Nikkei 225 index had climbed more than 7% over seven trading days, reaching a new high not seen in 34 years. Furthermore, today a Nikkei ETF was quickly chased in the market and, after rapidly reaching a peak, plummeted sharply, making for a harrowing roller coaster ride within the day.

However, with the multitude of ETFs available in the market, especially those listed on the US stock exchanges, the question of how we can choose and what we need to pay attention to are even more significant. These are the topics that this article will elucidate.

Currently, the most dazzling national indices on the market, aside from the United States, are those of India, Japan, and Vietnam. The ETFs (Exchange Traded Funds) listed in the United States cover markets all around the globe, providing investors with a relatively simple way to invest in the stock markets of these nations. Here are some examples:

• iShares MSCI India ETF (INDA): An ETF that tracks the performance of the Indian stock market, aiming to replicate the performance of the MSCI India Index.

• WisdomTree India Earnings Fund (EPI): This ETF invests in Indian market stocks weighted by company earnings.

• VanEck Vectors India Growth Leaders ETF (GLIN): Focuses on investing in companies that are performance leaders in India.

• Franklin FTSE India ETF (FLIN): Tracks the FTSE India Capped Index, which includes large and mid-cap stocks in the Indian stock market.

• iShares India 50 ETF (INDY): Tracks the Indian NIFTY 50 index, which includes the 50 largest companies by market capitalization in India.

• iShares MSCI Japan ETF (EWJ): Provides a way to invest in the Japanese stock market, tracking the MSCI Japan Index.

• WisdomTree Japan Hedged Equity Fund (DXJ): This ETF invests in the Japanese stock market and hedges against yen currency risk to minimize the impact of exchange rate fluctuations.

• JPMorgan BetaBuilders Japan ETF (BBJP): Tracks the Morningstar Japan Target Market Exposure Index, offering broad exposure to the Japanese stock market.

• Vanguard FTSE Japan ETF (VPL): Tracks the FTSE Japan Index, including companies of various sizes listed on the Japanese exchanges.

• SPDR Solactive Japan ETF (SJNK): Tracks the Solactive GBS Japan Large & Mid Cap USD Index, investing in large and mid-cap companies in Japan.

• VanEck Vectors Vietnam ETF (VNM): One of the best-known Vietnam market ETFs, it invests in companies listed in Vietnam as well as companies listed in other countries but with primary business operations in Vietnam.

Besides these, there are also a large number of leveraged ETFs. However, investing in these ETFs, especially leveraged ones, involves many considerations that need attention.

Leveraged Exchange-Traded Funds (Leveraged ETFs) utilize financial derivatives, such as options and swap agreements, to amplify the daily returns of the index they track. These products typically offer 2x or 3x the daily return, with the more well-known ones being triple-leveraged ETFs, like the QQQ.

However, due to their structure and operation, leveraged ETFs can experience performance decay when held over the long term, often referred to as "decay" or "erosion." This decay is primarily caused by the following factors:

Compounding Effect: Leveraged ETFs aim to provide a multiple of the benchmark index's daily returns. Since they reset every day, the compounding effect over time can lead to a deviation in long-term performance from the expected multiple returns. This effect is particularly pronounced in volatile markets, as leveraged ETFs need consecutive gains to compensate for previous losses and maintain alignment with the index.

Reset/Rebalancing Costs: Leveraged ETFs reset their leverage at the end of each day to maintain the predefined leverage level. This daily reset requires buying and selling derivatives, which can incur transaction costs, especially during periods of high market volatility. These costs accumulate over time and can lead to a decline in long-term performance.

Financing Costs: To achieve leverage, leveraged ETFs need to borrow capital or use derivatives. These operations incur borrowing costs or derivatives holding costs. These fees reduce the ETF's net asset value (NAV), thereby affecting long-term returns.

Volatility Decay: The decay of leveraged ETFs is particularly significant in volatile markets. Since they offer a multiple of daily returns, negative returns can disproportionately affect the value of the ETF in volatile markets. For example, if the market rises and falls by the same percentage on two consecutive days, the value of a leveraged ETF will decrease because the losses are magnified.

Management Fees: While management fees are a part of all ETFs, they can also impact long-term performance in leveraged ETFs, as investors not only pay the fund's management fees but also need to consider the additional costs associated with the above-mentioned leveraging operations.

Due to these factors, leveraged ETFs are generally not suitable for long-term investment. They are more appropriate for experienced investors for short-term trading or hedging strategies.

Let's take a simple example:

Suppose we have a leveraged ETF that aims to provide 2x the daily return of a benchmark index. Here is a simplified example to illustrate how, in a volatile market, the value of a leveraged ETF can decrease even if the total return of the benchmark index is zero.

Assumptions:

• The benchmark index starts at 100 points.

• The leveraged ETF starts at a price of $100.

• The ETF's goal is to provide 2x the daily return of the benchmark index.

Scenario:

Day 1, the benchmark index rises by 10%. The index moves from 100 points to 110 points.

￮ The leveraged ETF's return should be 20% (2x 10%).

￮ The new value of the ETF is $120 ($100 starting price + 20%).

Day 2, the benchmark index falls by 9.09% (which brings the index back to 100 points, because a 9.09% decline from 110 points is exactly 10 points).

￮ The leveraged ETF's return should be -18.18% (2x -9.09%).

￮ The new value of the ETF is $98.18 ($120 - 18.18%).

Result:

• At the end of the two days, the benchmark index returns to its initial value of 100 points, with a total return of 0%.

• However, the price of the leveraged ETF has decreased from $100 to $98.18, with a total loss of 1.82%.

This example demonstrates the decay caused by daily resetting in a volatile market, even when the performance of the benchmark index returns to the starting point. In reality, leveraged ETFs are also affected by management fees, borrowing costs, and rebalancing costs, which can further reduce the long-term value of the ETF.

Therefore, leveraged ETFs are more suitable for investors whose goal is short-term investment and who are capable of closely monitoring market movements. For investors seeking long-term investment strategies, the decay characteristics of these products may result in returns that do not meet expectations.

For ETFs targeting different countries, there are some standard requirements:

(1) Tracked Country and Region: The level of economic development, market size, political stability, and regulatory environment of different countries and regions can significantly impact the performance of overseas and cross-border ETFs. For example, an ETF that invests in the Nasdaq index, which is an important indicator of stock market trends in the United States and globally, is particularly reflective of economic health and growth potential in the innovation and technology sectors for investors tracking technology and growth companies. Therefore, it is essential to thoroughly research the macroeconomic conditions, monetary policies, trade relations, and potential risks of the target country before investing.

(2) Industry and Companies: Overseas and cross-border ETFs may focus on specific industries or companies. It is crucial to examine the growth prospects of these industries, market dynamics, and the financial health, competitive position, and future growth potential of the companies. Also, whether the target is diversified across multiple industries or concentrated in a particular sector will directly affect the risk exposure of the investment portfolio.

(3) Fund Company and Size Considerations: The cross-border ETF market is relatively small; as of December 15, 2023, there are a total of 106 cross-border ETFs in the domestic market. The distribution of ETFs shows a certain "80/20 effect," where the top 5 fund managers by size account for nearly 80% of the total. Large fund companies usually have better resources and management capabilities, enabling them to manage funds effectively, and may offer lower custodial fees.

(4) The Importance of Liquidity: Liquidity refers to the ability to quickly buy and sell assets without affecting the price. ETFs with high liquidity mean that investors can easily enter and exit the market when needed. Investors should check trading volume and bid-ask spreads to assess the liquidity of an ETF. ETFs with low liquidity may incur higher costs when buying and selling and may be difficult to close quickly during market volatility.

For example, a Nikkei ETF that experienced a dive today initially rose more than 9% in the early trading session but quickly plummeted towards the end, closing down over 4%, with a turnover rate reaching 607.18%. Its premium rate at one point rose to over 24% during the session but fell back to 9.45% by the close. The premium/discount rate arises from the difference between the net value and the trading price in the market; for instance, the net value represents the current performance of the fund, while the trading price in the market is determined by the secondary market trading price.

(Investors can subscribe to ETFs in the primary market and then sell them in the secondary market to complete arbitrage, but this can be detrimental to secondary market traders, who can easily be harvested by arbitrageurs.)

Warren Buffett once said, "What I often recommend is a low-cost S&P 500 index fund, but only a very few modest friends will believe me." Buffett's subsequent words carried deeper meaning: Almost no extremely wealthy investors, fund managers, or pension funds have truly followed my advice. They politely thank me, but then they are persuaded by asset managers who charge high management fees and choose another investment method.

When investing in global markets, if we are unfamiliar with a country's market or have doubts about stock research, yet we are optimistic about the assets of that country, the best investment strategy is to follow Buffett's "index investing method." At the same time, paying attention to some basic knowledge and risks will help us achieve investment success.