Michael Johnston:  Most investors looking to generate alpha and accumulate wealth over the long term spend the bulk of their time determining which asset classes should be included in their portfolio,either as long-term building blocks or shorter-term tactical allocations. But sometimes the most effective means of generating excess returns is not identifying and overweighting the top performers, but identifying and avoiding the laggards. Those with the good fortune to move out of financial stocks in 2008 or 2011, for example, have likely achieved better returns than many of their peers. The most important parts of your portfolio, in many cases, are the asset classes that are excluded entirely [see Five ETFs For Doomsday Capitalism].

Case Against Japan

Japan is one corner of the market that a growing number of investors see as a drag on returns and as such are looking to avoid when constructing their portfolios. The Asian economy has struggled for the better part of three decades; the benchmark Nikkei index is about 75% below its all time high set in the early 1990s, as the country has failed to generate meaningful GDP growth and maintain a thriving export market. More recently, a stubbornly strong yen has hurt the economy, and a mounting debt burden has begun to stoke anxiety among both domestic and international investors. Throw in the devastating impact of recent natural disasters, and the Japanese economy becomes undesirable to many investors with a focus on the long run [see also The Ten Commandments of Commodity Investing].

Despite the tremendous challenges and likelihood of low growth rates for the foreseeable future, Japan receives a huge allocation in the portfolios of many investors. Though the Japanese economy is not expanding quickly, it is one of the largest in the world–currently behind only the U.S. and China. So in ETFs linked to cap-weighted indexes, Japan generally gets a pretty hefty weighting. The market is the second largest country allocation in the popular iShares MSCI EAFE Index Fund (NYSEArca:EFA), representing more than 20% of assets. The MSCI Pacific ETF (NYSEArca:VPL) gives close to 65% of assets to Japan, with Australia, Hong Kong, and Singapore filling out the remainder. The broad-based Vanguard FTSE All World ex-U.S. ETF (NYSEArca:VEU), which has more than $6 billion in assets, has Japan as its highest individual country with about 15% of assets.

Asia Ex-Japan ETFs

For investors looking to rid their portfolios of exposure to Japan, there are a number of ETFs that explicitly exclude this economy, and as such may be effective ways to fine tune the geographic allocation:

MSCI All Country Asia ex Japan Index Fund (NASDAQ:AAXJ): This ETF is designed to offer investors equity exposure to 11 Asian countries, including both developed and emerging markets. AAXJ has an impressive depth of holdings with its basket of over 640 individual securities, featuring exposure to the emerging China market, the quasi-developed countries of South Korea and Taiwan, and the developed Hong Kong and Singapore markets. It is worth noting however, that AAXJ is tilted heavily towards giant and large cap companies, a common bias found in most international equity funds.

Asia Pacific ex-Japan Fund (NYSEArca:AXJL): For investors seeking to employ a dividend-focused strategy, AXJL is an attractive option for tapping into both developed and emerging Asian markets. The fund tracks a fundamentally weighted index that is designed to measure the performance of dividend paying companies in the Asia Pacific ex-Japan region. AXJL maintains a relatively well-balanced portfolio of around 240 stocks, spread out across a number of  sectors and countries. Although not as deep as AAXJ, this ETF is significantly cheaper with its expense ratio of just 0.48% [try our Free ETF Head-To-Head Comparison Tool].

MSCI All Country Asia ex Japan Small Cap Index Fund (NASDAQ:AXJS): Unlike most Asia Pacific ETFs, this fund provides investors exposure to small capitalization companies from developed and emerging equity markets. As opposed to its large cap counterparts, small cap companies tend to exhibit the highest growth potentials, which can provide a nice boost to portfolio returns. AXJS holds a deep and well-balanced portfolio of just over 820 securities, with weightings of no more than 0.53% allotted to an individual stock. Despite the AXJS’s small cap focus, it is important to note that the fund is predominately comprised of mid-cap stocks, which account for over two-thirds of the total assets [see First Ex-Japan Small Cap ETF Debuts].

Developed Ex-Japan ETFs

There are also a number of ETFs that target only developed markets in the Asia Pacific region, but exclude Japanese stocks entirely. For investors looking to obtain exposure to developed markets but hoping to steer clear of low growth Japan, these funds could be combined with a Europe ETF (such as VGK) to form a replacement for popular holdings such as EFA or VEA:

FTSE RAFI Asia Pacific ex-Japan Portfolio (NYSEArca:PAF): For investors who believe the RAFI methodology offers an opportunity to generate excess returns over the long run, PAF is an intriguing option. The fund is designed to track the performance of the largest equities of Asia Pacific companies, selected based on four fundamental measures of firm size. The resulting portfolio is relatively shallow and top-heavy with only 170 securities, of which more than 30% of the assets lie in the top 10 holdings. In terms of sector allocation, PAF is relatively well-rounded but does have a significant tilt towards financial services [see Does Your Portfolio Need A “RAFI ETF”].

MSCI Pacific Ex-Japan Index Fund (NYSEArca:EPP): This ETF focuses on the equity markets of four developed Asia Pacific economies: Australia, Hong Kong, New Zealand, and Singapore. Considering the fund’s targeted focus, its resulting  portfolio is relatively shallow with about 150 holdings, which are dominated by giant and large cap stocks. Currently, EPP allocates more than a third of its assets to the financial services sector as well as significant weightings to basic materials and real estate. With an expense ratio of just 50 basis points, EPP is one of the cheapest options on our list.

Asia Pacific Ex-Japan AlphaDEX Fund (NYSEArca:FPA): With its unique quant-based strategy, FPA might be an interesting option for investors who believe the AlphaDEX methodology has the potential to provide uncorrelated returns. FPA’s underlying index is constructed by a quant-based screening process that identifies stocks poised to outperform their broad peer group. With just under 100 holdings, the fund’s portfolio is relatively shallow and is heavily biased towards the real estate and industrials sectors. Although the AlphaDEX methodology has the potential to generate excess returns, it comes at a higher price with an expense ratio of 0.80% [see AlphaDEX ETFdb Portfolio ].

Written By Michael Johnston From ETF Database   Disclosure: No positions at time of writing.

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