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For ETFs, Flows Into Japan Could Be an Ominous Sign

Shares in Tokyo dropped following the deadly March 11 earthquake and tsunami
Yoshikazu Tsuno | AFP | Getty Images
Shares in Tokyo dropped following the deadly March 11 earthquake and tsunami

That sound of pounding hooves you’ve been hearing is of investors entering Japan, not leaving the disaster-ravaged country, which has become an unlikely darling for fund money.

Inflows into Japan ETFs since an earthquake and tsunami ravaged the nation have confounded market strategists and generated as many cautions as buy signals.

But what is happening, in fact, may be part of a clear paradigm shift in exchange-traded funds, where institutional investors increasingly call the shots and are leading the flow away from emerging markets and into more selective national and natural resource plays.

So how to explain the flock of money into a country that will take years to rebuild and likely act as a drag on global GDP growth?

“We’ve seen money come out of generic emerging market funds, but even that’s only a piece of the puzzle,” said Nick Colas, chief market strategist at ConvergEx.

Japanese ETFs—in particular the iShares MSCI Japan fund—saw inflows of nearly $1.2 billion over the past week, with most of that coming in the ETF category and just $19 million from other funds, according to Lipper data.

The EWJ is the most popular source of ETF money this year, with inflows of $2.4 billion, easily outdistancing the second-place iShares Brazil ETF and the iShares Canada .

By contrast, emerging market ETFs have seen a drop of 0.7 percent in assets year to date, while developed international funds have lost 0.6 percent of assets.

That has happened even as the Japan fund has lost about 4 percent in value for the year.

“The day everything happened (inflows were) flat and it has been seeing inflows ever since,” Colas said. “That was unexpected to say the least, but people clearly see an opportunity there.”

Whether it’s actually “people” who see that opportunity is unclear, though.

Such a huge inflow would be suggestive not of retail investors calling the shots but of institutional money piling in to push a fund higher, Colas said.

Taking that argument a step further, the improbable flows into the EWJ could be a classic momentum play that could leave overeager investors burned. (Alphaville’s Izabella Kaminska and Devin Riley at Index Universe both have pointed out in recent days the high premium at which the Japan ETFs are trading.)

Indeed, the frothy optimism is hard to miss in today’s marketplace.

Hedge fund manager Dennis Gartman said he has been buying the Japan ETFs, but wondered Tuesday whether his money shouldn’t be spread around elsewhere in the country.

“[T]he more we consider the job ahead of renovating and rebuilding the prefectures flattened by the tsunami, perhaps it might be wisest to own Japanese large equipment manufacturers. Large earthmovers, large trucks, front-end loaders, cranes and the like shall be in demand,” he wrote in today’s “The Gartman Letter.” “If the market likes Japanese shares generally, it will love these companies the most…or at least that would seem both reasonable, logical and now ‘technically’ wise.”

Canaccord Genuity, likewise, noted the plethora of Japanese enthusiasm, noting comments made from Warren Buffett and Gluskin Sheff’s David Rosenberg advising investors to jump in with both feet, or as Canaccord put it, to “buy Japan with both hands.”

But there are any number of catches to the Japan trade.

Dave Lutz, managing director of US trading at Stifel Nicolaus, points out that while the EWJ is dollar-denominated its assets are marked in yen. So if the Bank of Japan intervenes to devalue its currency, that could leave investors exposed to a serious drop in fund value.

Also, those ETF buyers are unlikely to be all in the business of being long Japan.

“Out of that $1.2 billion, I’m sure there is a certain percentage that is for the lending market to facilitate short selling, but there is no exact way to tell,” Lutz said.

Trim Tabs market research firm points out that erstwhile market bear Marc Faber told CNBC last week that Japan presents the buying opportunity of a lifetime, something “which might make contrarians wary of bottom fishing in Japan just yet.” The firm points out that EWJ issued $1.1 billion from March 15 to 17 even though the fund dropped 8.1 percent in price for the five-day period inclusive.

For Colas, the shift in ETF preferences and the surge in volume to individual funds is reminiscent of what happened to options. Institutional investors, with their high-frequency trading and market-making dominance, took over that sphere, and they appear to be making a play for ETFs now.

“If you had told me what was going to happen in Japan and asked me what the EWJ was going to see, I would have guessed at least a billion would have left, and it’s just the opposite,” he said. “Maybe you’ve got some maturation of the ETF universe. We always think of ETFs being dominated by retail flows, but a billion dollars a week doesn’t feel like retail flows.

“Think about what options used to be 10, 15 years ago. Options were purely a retail play. Now it’s matured into a market where institutional dominates. I think you’re seeing the same thing with ETFs.”

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