Japan's Currency Conundrum (TOK, EWJ, FXY)

It's as simple and as relevant as the day is long: Japan, the world's third-largest economy behind the U.S. and China, is an export-driven economy and that economy is extremely sensitive to currency fluctuations. Or maybe it's more constructive to just say a strong yen is bad news for Japanese exporters.

This scenario prompts the Bank of Japan to engage in currency intervention campaigns with mixed results. In 2012, the results have been strong as the CurrencyShares Japanese Yen Trust (NYSE: FXY) is off almost 7% year-to-date.

"In the wake of last year's devastating earthquake and tsunami, the Bank of Japan (BOJ) has aggressively expanded Japan's monetary base to $1.37 trillion in an effort to stabilize the economy, pressuring the yen, by our analysis," S&P Capital IQ said in a recent research note.

S&P Capital IQ goes on to note a weakened yen has bolstered EPS expectations for major Japanese exporters, good news considering export-heavy sectors such as industrials, consumer discretionary and technology account for almost 54% of Japanese equity market cap.

Unfortunately, there is another side to the weakened yen and it is that it diminishes returns for U.S. investors in Japanese equities and ETFs and S&P notes the "catch 22 dynamic."

"Unfortunately, negative currency translation has negated any year-to-date alpha for U.S. investors. When Americans buy foreign stocks, their returns suffer when overseas currencies fall versus the U.S. dollar. Hence, the greenback's 6.7% year-to-date gain versus the yen has substantially eroded U.S. investors' dollar-denominated Japanese equity returns. While the MSCI Japan Index is up an impressive 17.6% in local currency terms, its gain dwindles to only 10% when measured in dollars, trailing the broader MSCI EAFE's 10.4% year-to-date gain, as well as the S&P 500's 12.4% advance," according to the research note.

The iShares MSCI Japan Index Fund (NYSE: EWJ) is the ETF that tracks the MSCI Japan Index. Home to almost $5.6 billion in assets under management, EWJ is up nearly 8% this year. Investors must also consider that yen weakness may not last for extended period.

"Unfortunately for U.S. investors, even if the yen's recent weakness abates, we believe they would simply be trading currency translation pressure for renewed export jitters as a stronger yen threatens overseas appetites for Japanese goods," S&P said.

As a result, the firm prefers the iShares MSCI Kokusai Index Fund (NYSE: TOK), which it has an Overweight rating on. That fund is up 10.3% year-to-date. TOK, an ex-Japan developed market ETF, devotes more than two-thirds of its weight to the U.S. and U.K. Canada, Switzerland, France, Australia and Germany are the next five country weights.

Home to almost 1,250 stocks, TOK features nine U.S.-based companies among its top-10 holdings with the exception being Nestle (PK: NSRGY), the world's largest food company. For those still not compelled to give TOK a look, maybe this will do the trick: Apple (Nasdaq: AAPL) is the ETF's top holding, though the tech juggernaut represents just 2.59% of TOK's overall weight.

By The ETF Professor