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Don't misjudge Japan's equity boost

Japan funds have delivered strong returns over the past 10 years and look well positioned to make further gains
August 4, 2016

Many investors recoil at the mention of investing in Japan because of memories of poor returns in the 1990s, but this market has generated strong returns over the past 10 years and new economic stimulus could mean another equity boost. So when you are allocating assets, don't misjudge Japan.

If you'd invested in Japanese equities around the time prime minister Shinzo Abe was first elected in 2012 you would be patting yourself on the back. Some of the best-performing funds are now up by more than 200 per cent in five years, driven by Mr Abe's package of reforms aimed at igniting the market.

The risk is that this stimulus has been used one too many times, and that no fuel is potent enough to ignite Japan's ailing economy. Since Mr Abe first unleashed his three arrows reform package the market has surged on the back of a weak yen, but the government is fast running out of tools. Last week the Bank of Japan (BoJ) decided to hold rates and asset purchases at the same level, but tweak the volume of exchange traded fund (ETF) purchases in a move that underwhelmed markets.

It is the latest sigh of frustration from investors who are losing patience with so called Abenomics. Mr Abe's three arrows of quantitative easing (QE) and monetary expansion, fiscal policy and corporate cultural change, have not yet triggered more spending or dragged up stubbornly low inflation. At the start of 2016 the yen, which had been falling, started to strengthen again in a sign that markets were losing faith.

But things are shifting. Corporate governance is improving and last month a bright spot appeared on the horizon when official figures revealed Japan's economic growth had exceeded analyst expectations and an earlier growth estimate was revised up.

Darius McDermott, managing director at Chelsea Financial Services, says: "Mr Abe has introduced some inflation into the economy and tourism is really taking off. Attitudes among companies have also started to change and companies are actually thinking about their shareholders.

"When you think about two decades of deflation Abe has done a pretty good job. This was never going to be an overnight phenomenon. The first arrow happened quickly, but that was the most straightforward one. The third arrow is taking longer and it is in many ways a shame that Mr Abe hadn't been given longer to get it done. But this new mandate should give him the support he needs to really push through change."

There is no doubt, either, that Japanese markets over the past 10 years have delivered stellar returns for UK investors. Over 10 years MSCI Japan is down 2.1 per cent in local currency, but up 55 per cent in pounds sterling. Over five years, it is up almost 60 per cent - a far better return than the FTSE 100's.

 

Japan funds to match your risk appetite

When it comes to choosing a Japan fund you could opt for the funds that have performed well in the past five years during a QE-fuelled growth environment, or buy a fund that has not performed well but could start to if the market falls. Alternatively you could opt for a defensive income fund and put your faith in new measures aimed at corporate governance.

"A select band of funds have done very well, and those are smaller companies funds and funds invested in growth-orientated sectors such as healthcare and technology," says Rob Morgan, analyst at Charles Stanley Direct.

Because the package of measures unleashed by Mr Abe is more of the same, there is no reason to think that the funds which have done well would suddenly start to do badly, according to Mr McDermott. "I see nothing that tells me the style in favour should suddenly change," he says.

The best performing open-ended fund over the past three years is Legg Mason IF Japan Equity (GB00B8JYLC77), a volatile open-ended fund invested in a subsector of high-growth, technology-themed companies known as 'New Japan'. Its portfolio includes companies focused on technological disruption in sectors such as biotech and software, and it has more than 40 per cent allocated to healthcare. Over five years it has returned 274 per cent against just under 60 per cent for the Topix index. But it can spend long periods underperforming the market, and Mr Morgan says it is always either in the first quartile or fourth quartile of the Japan sector in terms of performance.

"It has a small- and mid-cap bias and is really volatile," adds Mr McDermott. "If you get the timing wrong you lose a lot of money, but if you are a long-term holder you can also make a lot."

This fund has an ongoing charge of 1.01 per cent and it has a hedged share class, with an ongoing charge of 1.11 per cent. The hedged class was only launched in 2013 and has not outperformed its unhedged peer over three years due to the dramatic appreciation of the yen at the start of 2016.

Mr McDermott highlights Baillie Gifford Japanese (GB0006011133), which he describes as "less of a rollercoaster ride and more large-cap focused". Managers Sarah Whitley and Matthew Bret look for high-quality companies delivering sustainable earnings growth. The fund's top 10 holdings include SoftBank (4726:TYO) and Misumi (9962:TYO). In the medium term it has returned less than Legg Mason IF Japan Equity (unhedged), but over the long term has performed well.

Fans of investment trusts can also buy Baillie Gifford Japan Trust (BGFD)*, also run by Sarah Whitley, which has outperformed Baillie Gifford Japanese by some margin over three and five years. It has a small- and mid-cap bias and is the top-performing trust in the Association of Investment Companies (AIC) Japan sector over five years. It is trading on one of its widest discounts in two years - probably a reflection of the recent move in the yen. However, this has a higher ongoing charge of 0.91 per cent, against 0.67 per cent for the open-ended fund.

The standout Japan trade in recent years has been small-cap stocks, which have benefited from Abenomics and dramatically outperformed large-caps. An investment trust that has beaten the market by a large margin in this area is Baillie Gifford Shin Nippon (BGS)*. Over five years it has returned more than 230 per cent against just under 80 per cent for the MSCI Japan Small Cap Index by investing in fast-growth businesses with a focus on disruptive technology. Manager Praveen Kumar, who took over the trust at the end of last year, invests in under-researched stocks with the potential to disrupt global markets. Holdings include Nippon Ceramic (TOK:6929), a new holding that commands 50-60 per cent of the global market in crash avoidance sensors used in one of the most talked-about industries of the future - driverless cars. It has a 90 per cent share of this market in Japan.

CF Morant Wright Nippon Yield (GB00B2R83B20) also offers some exposure to small-caps. Jason Hollands, managing director at Tilney Bestinvest, recommends it as a multi-cap fund "with a quality-value bias". It has 33.8 per cent of its assets in small-caps and 37.2 per cent in mid-caps, and screens for stocks in a position to grow dividends. This means that, as well as performing well on a total return basis, it yields 2.5 per cent.

That is a sign of the growing importance placed on dividends by Japanese companies, which have traditionally hoarded cash on their balance sheets. And an income focus could add a defensive slant to your exposure. "It is now possible to get a decent yield from Japanese equities, which in the past would have been unheard of," says Mr Morgan. "Today you can get as much as a 3.5 per cent yield fairly easily from a diverse portfolio of equities, which provides some downside protection."

He also likes CC Japan Income & Growth (CCJI), a relatively small investment trust launched at the end of last year that yields 3.2 per cent. It is managed by Richard Aston at specialist Asian equity boutique Coupland Cardiff.

"This focuses on undervalued businesses from across the market-cap spectrum with strong balance sheets that have consistently grown their dividends, and a small number of special situations," adds Mr Hollands. "Approximately 46 per cent of the portfolio is in larger companies, 36 per cent in mid-caps and 18 per cent in smaller companies."

Investment wisdom suggests that styles and sectors which have recently outperformed are likely to be at the bottom of the pile when the cycle shifts. If markets fall definitively out of love with Abenomics this year, value-style investing could come back into fashion. In which case Man GLG Japan CoreAlpha Fund (GB00B0119B50) could be a good option. "This fund is one of the most contrarian investments available," says Mr Morgan. "It invests in a particularly unfashionable market."

The fund's manager, Stephen Harker, takes a high-conviction approach and looks for cheap larger companies that have underperformed, selling them when they start to perform well again. As a result, its portfolio looks different to those of many other Japan funds. Currently GLG Japan CoreAlpha is overweight in banks - an area most managers are avoiding due to the impact of negative interest rates. Mitsubishi UFJ (8306:TYO), Nomura (8604:TYO) and Sumitomo Mitsui Trust (8309:TYO) are among its top 10 holdings.

Although it may be out of favour now, over the long term the fund's performance has been impressive, delivering a return of more than 100 per cent over 10 years against just under 60 per cent for the Topix index.

Value funds could also be better if there is a market shock because they tend to hold shares with low prices. "When we do have a market shock, a value fund gives you the buffer of cheap valuations, whereas growth funds tend to be more affected by bad surprises because they are more expensive," explains Mr Morgan.

The fund also has a hedged share class (IE00B64XDT64), recommended by Adrian Lowcock, head of investing at AXA Wealth. But over one, three and five years the hedged share class has not outperformed the unhedged one due to the strengthening yen this year.

 

The impact of currency and hedging your Japanese bets

A key element of Mr Abe's economic reform is aimed at devaluing the yen and making exports more competitive. If this works, a hedged fund could be better. In 2013 MSCI Japan GBP hedged index returned more than 50 per cent compared with just 24 per cent for the unhedged version of the index, during a year when the yen slid against sterling.

"With political support behind him Shinzo Abe is able to continue with his Abenomics policy to generate growth, create inflation and reform Japan's businesses," says Mr Lowcock. "Part of that policy has been targeting a weaker yen as a strong currency is a significant headwind to growing the Japanese economy. With a new mandate I would expect Shinzo Abe to once again target a weaker yen.

"For UK investors, the pound is likely to strengthen against a Japanese yen where any devaluation will have the full support of the Bank of Japan. In this environment hedging your yen exposure when investing in Japan will help protect you from the fall in the value of the currency and benefit from a rising stock market that typically comes with a weaker yen."

However, this year the yen has stubbornly refused to budge and, if markets remain suspicious of the efficacy of Abenomics, it will not have been worth paying extra.

*IC Top 100 Fund

 

Performance (% cumulative total return) of recommended Japan funds and investment trust share prices

Funds 1-mth3-mths6-mths1-yr3-yrs5-yrs10-yrs
Legg Mason IF Japan Equity -4.6711.7238.5559.69100.84273.95156.2
Legg Mason IF Japan Equity Hedged in GB-3.84-3.2110.6111.8577.07
Baillie Gifford Japanese 6.7114.0424.6116.9234.4486.3100.31
Baillie Gifford Japan Trust 7.269.5115.128.547.36137.31108.07
Baillie Gifford Shin Nippon5.7127.0438.8941.2999.33231.65186.68
CC Japan Income and Growth Trust 7.066.8114.99
Man GLG Japan CoreAlpha 9.428.179.63.5221.9248.0895.25
Man GLG Japan CoreAlpha Equity Hedged to GBP 9.958.99.92.7318.7918.7944.63
CF Morant Wright Nippon Yield 9.9115.9317.3319.5142.7185.69
TOPIX index6.2312.317.9114.6630.2858.1158.1
MSCI Japan Small Cap index5.2914.3423.3426.848.8478.8391.71
MSCI Japan index8.3713.417.0515.6132.3156.2254.01

Source: FE Analytics, as at 29.06.16