ETFs May Not Always Do What You Think: Example of Japan Nikkei and EWJ

Apr 13, 2011: 12:56 PM CST

Exchange Traded Funds are gaining wide popularity for investors and traders alike, and for great reasons.  I need not trumpet the many benefits of trading or investing with ETFs.

However, I wanted to bring up a recent example of Japan and the spike in trading of the popular EWJ ETF which left a few invstors bewildered, especially if they were tracking along with Japan’s Nikkei Index.

Here – Let’s see what the assumption was and what went wrong on the chart:

First, let’s chart Japan’s Nikkei Index:

Although I’ve labeled a clean five-wave move up into the 10,800 level, I wanted to call your attention to what happened after mid-March’s earthquake/tsunami/nuclear crisis – namely the sharp rebound in the index from the 8,200 ‘panic’ low to the recent 9,800 resistance level.

Generally, traders like to play bounces from panic situations on charts – it’s a very risky reversal (or mean reversion) strategy that can pay-off quickly for those risk-seekers willing to step in front of terrible news (and terrible price falls on the chart) and buy while others across the globe are selling ferociously.

Even a move from 8,800 or 9,000 to the current 9,800 level was an 8% to 10% possible move that risk-seekers could have enjoyed a quick profit.

The 9,800 level is now seen as a critical resistance level that could spark the end of the rally and the beginning of a downturn… or from a more bullish standpoint, any firm breakthrough above 9,800 then 10,000  ups the odds that the Nikkei will re-test the prior highs.

But I’m getting ahead of myself.

Say you called the bounce correctly and sought to profit from it using the popular EWJ (iShares MSCI Japan index), you might have been surprised with an unexpected recent loss as the EWJ share price declined while the Nikkei remained at resistance.

This is the EWJ recent chart:

First, the EWJ did not have the clean 5-wave stair-step pattern up as the Nikkei did.  The EWJ took a more straight-line rally with almost non-existent retracements to the rising moving averages.

Second, and more significant – though the EWJ fund bounced up off the mid-March panic low (again allowing profit from aggressive/quick traders), the fund also retraced into resistance (this time the 20d EMA) but then took a sharp dive over the last two weeks while the Nikkei remained poised under its resistance level.

That meant that if EWJ traders didn’t exit their aggressive ‘mean reversion’ swing trade into the $10.60 level, their profits quickly diminished as price fell from this level – unlike the Nikkei which flat-lined at resistance.

Keep in mind, however, that the EWJ is NOT tied to the Nikkei Index, but instead to the MSCI Japan Index Fund (link via Yahoo Finance).

This is another example of how important it is to take a few extra minutes to read information on ETF structure along with composition and goals, else you could wind up with different trading (or investing) results than you intended, even though your trade thesis/logic was ultimately correct.

Also, overseas ETFs may be subject to effects from currency fluctuations (particularly the recent volatility in the Yen) moreso than ETFs based on US Indexes or Sectors.  But that’s another issue.

ETFs are a great tool to play macro-events, particularly in countries, currencies, and commodities without using the FOREX or Futures market, but always take a moment to read what the ETF is,  and what goals the fund seeks to accomplish (or what index the fund tracks).

Otherwise, you could get your analysis correct, but still not profit the full amount due to factors about the ETF you selected to trade.

Corey Rosenbloom, CMT
Afraid to Trade.com

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2 Comments

2 Responses to “ETFs May Not Always Do What You Think: Example of Japan Nikkei and EWJ”

  1. j'adoube Says:

    But is that a classic 3-wave correction in EWJ?

  2. MOG Says:

    THE MAIN REASON THERE IS A TRACKING ERROR BETWEEN EWJ AND THE NK225 INDEX IS THE CURRENCY EFFECT ON THE EWJ.
    YOU ARE BUYING A YEN BASED ASSET IN DOLLAR TERMS. THE YEN WEAKENED AGAINST THE DOLLAR FROM 76 TO 85 DURING THE SNAP BACK RALLY IN THE NK225; THEREFORE, THIS BASE CURRENCY WEAKNESS AGAINST THE DOLLAR WILL BE EXPRESSED IN THE UNDER PERFORMANCE OF THE EWJ WHEN COMPARED TO THE NK225.
    CURRENCY MOVES HAVE TO BE CONSIDERED WHEN TRADING ETFs ON FOREIGN BASED INDICES, ESPECIALLY IF THE CURRENCY SWING AGAINST THE DOLLAR IS GOING TO BE LARGE.