Since the election of Japan's new government at the end of last year which is implementing reforms to boost the economy, some investors have invested in the hope that 20 years of equity market stagnation are over.
So far the Japanese market has enjoyed a strong run under the new government. Another attraction is that valuations are incredibly low making it one of the cheapest developed markets, which could provide some downside protection if things don't go as well as anticipated. There are also a number of multinational companies listed in Japan which would benefit if the global economy improves, in particular China and the US.
Government measures to boost growth include an unlimited asset purchase programme and a 2 per cent inflation target. This is helping lower the value of the Yen against currencies including sterling, which should boost the profits of Japanese exporters. But for UK based investors with Japan funds this is detrimental, because even if the shares in their funds are rising when this gets translated back they will lose out if the Yen is weak against sterling.
For this reason some advisers suggest that if you invest in Japan, you should hold a fund with a Sterling hedged share class.
"The Japan stock market boom may be a currency trap," says Damien Fahy, head of research at wealth advisers Dennehy Weller. "Prospects for Japanese equities are rapidly improving but a collapse in the Yen will hit returns of UK investors in most Japan funds. The current noise coming out of most investment banks can be summed up as buy the Japan stock market, short the Yen. This is because while Japan may be one of the cheapest sectors in the world and at some this sector should explode upwards, with vast amounts of debt and an ageing population, Japan is now very close to the point where it has to inflate its debt away, probably via massive central bank action. This could cause the Yen to collapse. For sterling investors the subsequent loss due to any currency exposure would hit returns made from the stock market.
Investors with exposure to the yen gain from stock market rises, but lose out from the falling currency
For example, in the last year the Nikkei was up 27.86 per cent in yen but just 5.14 per cent rebased in Sterling."
Adrian Lowcock, senior investment manager at Hargreaves Lansdown, is of a similar view: "Currency plays a major role in Japanese investing as a weak Yen usually coincides with a rising stock market, so investors with exposure to the yen gain from stock market rises, but lose out from the falling currency."
However hedging has its downsides. If the yen strengthened against sterling you could miss out on returns.
"A hedged fund tends to be more volatile so might not suit all investors," adds Mr Lowcock. "There is a cost to placing the hedge and the longer you hold the fund the greater the impact of that cost would be. However, given the impact currency movements can have on over all performance the cost of the hedge would be relatively inconsequential compared to whether or not it was the right decision to buy the hedged fund over the non-hedged version."
A few Japan funds offer hedged share classes including two exchange traded funds (ETFs), which a number of investors favour because many active managers fail to beat Japanese equity markets.
iShares MSCI Japan Monthly GBP Hedged (IJPH), launched last July offers exposure to more than 300 of the largest Japanese companies for a total expense ratio of 0.64 per cent. It follows the MSCI Japan 100 per cent Hedged to GBP Net TR Index which incorporates a monthly hedge using a one month forward foreign exchange contracts to reduce the effect of currency fluctuations between Japanese Yen and Sterling. The ETF also builds in currency hedging and replicates the index by holding physical shares.
db X-trackers MSCI Japan GBP Hedged TRN Index ETF (XMJG) has a TER of 0.6 per cent, and uses synthetic replication - gets its returns via a derivative swap rather than buying the shares.
It is difficult to judge how well either of the funds have tracked their index because they were only launched last year. Because they are relatively new they are also quite small which could mean they could be less liquid: the db X-trackers fund has assets of around £295m and the iShares fund has assets of around £27m.
Active fund options include IC Top 100 FundGLG Japan Core Alpha (IE00B665M716) with a TER of 1.89 per cent, which offers both hedged and unhedged share classes. It is one of the top performing Japan funds over five years though has not done so well over recent periods because of its bias to technology shares which have lagged behind defensives. But its manager believes these are attractively valued and could outperform.
This fund has also recently reopened to new investment. Read more on this here
Mr Fahy also suggests Neptune Japan Opportunities (GB0032076043) which is around 85 per cent hedged. It is one of the best performing Japan funds over one and five years, and has also beaten its benchmark, the TOPIX, by a massive amount over five years.
Meanwhile offshore fund JOHCM Japan (IE00B6386R19) offers a hedged share class and is the top performer in its offshore sector over five years. It beats the TOPIX by a considerable margin over one, three and five years, and has a TER of 1.49 per cent.
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