DFJ: Dividend yield not good enough for this niche strategy
With relatively poor performance over the past 3 years, the WisdomTree Japan SmallCap Dividend ETF (NYSEARCA:DFJ) is a unique Japanese equity strategy. With our uneven track record and managing unwieldy 711 sets, we are believes the strategy lacks high conviction ideas and requires better position sizing. We rate the ETF as a sell.
The WisdomTree Japan SmallCap Dividend ETF tracks the WisdomTree Japan SmallCap Dividend Index (WTJSC). There are 711 holdings in the fund, it has an expense ratio of 0.58% and currently has an expected dividend yield of 3.44% over 12 months.
In this piece, we want to assess the following:
- look at the technical analysis to see the short and long term performance of the fund.
- portfolio construction despite the limited disclosure available.
We will take each in turn.
Appearing low risk and low reward
DFJ has an adjusted beta of 0.88 against the Topix index, suggesting comfortably lower volatility than the Japanese market as a whole. However, from a relative performance perspective, we see that it started to underperform the broader market from mid-2019 and continued to do so by almost 15% (see chart relative performance against the iShares JPX-Nikkei 400 ETF). The cumulative performance shows a fairly poor annual equivalent return of 2.17% over the last 5 years (see cumulative performance table).
On a positive note, despite its focus on small caps, DFJ has significantly outperformed the Japanese TSE Mothers Small Cap Growth Indices by 17.5% over the past 3 years (and an impressive 32% over the past 5 years ). Despite this, investors would have fared better in the short and long term with the broad MSCI Japan index, pointing out that there doesn’t seem to be much upside with this small-cap product. The expense rate of 0.58% is a standard and acceptable level for management fees.
A quick look at beta, performance and expense ratio shows that investors are not paying too much for this niche product. Return expectations can also be limited, with access to stocks in the local economy (which would typically fly under the radar of standard funds) being the primary motivation for investing. We take a look at portfolio construction to see what DFJ offers from this perspective.
Looking fuzzy despite targeting a specialized asset class
The fund holds its largest holdings by sector in industries at 25%, a standard level for many Japanese ETFs. Consumer cyclicals come in second at 16%, followed by materials at 15% and financials at 13% – again all very standard allocations and nothing too unusual.
What stands out at DFJ is the very large number of holdings at 711. In an active strategy, you would be very challenged to keep pace with so many positions – although these are an ETF, the model of the strategy must have hard and wide parameters to select and position as many companies.
The top 10 positions held accounted for 6.67% of the portfolio, meaning there is a very long tail of minor small cap holdings making up the majority of the fund. Some of them may be very illiquid, which would explain the position sizing methodology.
The largest holding at 0.83% is Nishimatsu Construction (1820), a general contractor with a market cap of JPY212 billion/USD1.7 billion. This is a good selection of stocks, up 33% on last year and outperforming the Topix index by 43%. Valuations look cheap on a FY3/2023 P/E of 9.5x and an estimated dividend yield of 5.8%, but a cash-consuming business can be in trouble down the line.
We see other top-tier holdings that have decent dividend yields, but perhaps have questionable prospects as sustainable businesses. Konica Minolta (4902) (OTCPK:KNCAF) has an estimated dividend yield of 6.2%, but its core business remains office copiers (we are negative on its Canon counterpart (CAJ)). Toyo Seikan (5901) is a former growing can and container maker that faces an uphill struggle to generate free cash flow, despite offering a 5.8% yield. Seven Bank (8410) operates the ATM network used in Seven-Eleven convenience stores (operated by Seven & i Holdings (OTCPK:SVNDY)), under pressure from digital transformation. As a nationwide leader in the distribution of electrical appliances, K’s Holdings (8282) has limited room for growth with consumer spending under pressure. Regional bank Mebuki Financial Group (7167) (OTCPK:MEBUF) offers very little that a Japanese megabank like Sumitomo Mitsui Financial Group (SMFG) cannot.
Our main takeaway here is that the fund doesn’t offer much value in tracking the WisdomTree Japan SmallCap Dividend Index. Position sizing skills appear marginalized, and primary value picks lack high conviction, as evidenced by the large number of positions held. Overall, we don’t see the benefit of having access to Japanese small caps as an asset class in this product and format.
Japanese equities as an asset class have some appeal from both a value and growth perspective and remain a deep market with many sectors and market capitalization range. However, as an 8% allocation to the MSCI World Index, this is not a “must have” element in many global funds. You would think that Japan is a real stock-picking market (as opposed to buying a NASDAQ or FTSE tracker), and funds that exemplify this include the Baillie Gifford Shin-Nippon and the JPM Japan Fund. These active strategies would charge higher fees, but we believe they would provide better management for investing in Japanese equities. DFJ’s forward-looking 12-month dividend yield of 3.44% is too low to be attractive – we rate this ETF as a sell.