Sun rises on Japan, again

At the end of August, the Democratic Party of Japan won a landslide victory, breaking the 50-year stranglehold of the Liberal Democratic Party. Although the immediate Japanese stock market reaction to the elections reinforced the negative market view of Japan, fund managers believe the new regime will have a positive effect in the longer term.

Any investment in Japan should be seen in the context that UK investors are becoming increasingly aware of the need to diversify overseas. As Dr Stephen Barber, who advises Selftrade on economics comments: "If the global economic downturn has shown investors anything, it is that returns are now to be found from across the world. After all, the strength of the FTSE 100 over recent months can in part at least be credited to strength in China and other emerging economies since this leading UK index is so internationally exposed.

"With the UK itself representing no more than 10 per cent of global markets, diversifying overseas has become both more necessary and easier. Index tracking products such as exchange-traded funds allow cheap and transparent access to markets from the four corners of the world. In turn, this allows investors to take an asset allocating approach to world markets without the need to stock pick."

There has been so much said about the BRIC countries (Brazil, Russia, India and China), and particularly China in recent years, that any well-informed investor will have some exposure to at least the Beast of the East. But diversification should not stop at China.

One of the world's most important economic powers, Japan is also one of the key global stock markets, with Japanese manufacturers being world leaders in several major industries. However, Japan is largely ignored by UK investors.

Undeserved reputation

"Everybody thinks Japan is a terrible investment, but it's been outperforming the US for 11 years," says Stephen Harker, fund manager of the GLG Japan Core Alpha fund. In fact, if you were investing in sterling, Japan was the best performing market in 2008 because the yen was super strong. Mr Harker explains: "As a sterling-based investor, if the yen goes up you're making money. This year, the yen has been weak against sterling. But we're not bearish about the yen."

There are two big reasons to look at Japan funds more closely. The first is that corporate Japan is largely unleveraged and should be positioned to take advantage of this position over the highly leveraged West.

"The credit crunch since July 2007 has caused shrapnel wounds to Japan," says Mr Harker. "But it's not Japan's fight. Japan is obviously part of the world economy, but is not involved in the deleveraging credit crunch. Japan had its hell post '89 - it had mountains of debt that were unmanageable and had to be worked out. However, Japan has been working out its bad debt for a long time."

Meanwhile, he thinks that the UK and US are facing their own version of the Japan problem. "The response will be different, but the pain will be drawn out," he says.

"We think Japan is starting to be uncorrelated with the rest of the world because it has flushed its debt out already. Japanese financial institutions had been expanding globally pre '89 and then withdrew to their core domestic markets. The same is happening with the US and UK banks, creating a vacuum - and we think Japan will move in."

Election watershed

The second reason to invest in Japan is the recent change in government. That the recent Japanese elections were won in a landslide victory by the Democratic Party of Japan (DJP) is generally perceived as good news, with the main policy shift expected to be towards a more consumer -friendly, 'economic revival through higher living standards' stance.

However, Jonathan Schiessl, investment manager of the Ashburton Asia Pacific Equity Fund says: "Blink and you would have missed the stock market's reaction to Japan's momentous election result."

On the day following the result (31 August), the Nikkei actually fell 0.39 per cent. He compares this with the extraordinary reaction on 18 May of India's markets to the decisive Congress Party's election victory. The Sensex gained over 17 per cent in a little under two minutes. "To say Japan's reaction was somewhat more muted is an understatement of titanic proportions," says Mr Schiessl. "But, in fact, it is merely a reinforcement of the same old negative market view of Japan as a basket case, unable to change.

"To be fair to the bears, we have had almost six decades of the 'same-old, same-old' in Japan, so history is on their side. But, from our perspective, we really do see this election result as a hugely important one as the DPJ won 306 out of 480 seats."

He explains that the Liberal Democratic Party (LDP) was decimated, winning just 119 seats, and will have no residual influence over policy-making. Plus, many current and former LDP heavyweights lost their seats, leaving the DPJ controlling both houses.

So what does this mean? "The party that has ruled Japan virtually uninterrupted for over 50 years has been obliterated," says Mr Schiessl. "The populace has delivered the DPJ a huge mandate, which, while widely expected, not even the most optimistic DPJ supporter could have expected - especially as the weather was foul and the government announced (rather suspiciously) that a swine flu epidemic was building. With record turnout, the landslide result rested on a general acceptance and desire for a change from a bureaucracy-driven policy process.

"As far as we are concerned, this result has changed something. It's changed the idea that Japan is unwilling and unable to change. The electorate has delivered the mandate and now it's up to the DPJ to deliver the result. This will undoubtedly take time and face considerable hurdles on the way."

Milestones approaching

A crucial test comes in October when the Cabinet Act is amended to introduce Cabinet style government to Japan. "This is where we will likely see the bureaucracy mount resistance," says Mr Schiessl.

Next, in December, comes the drafting of the Budget Bill, which will begin to flesh out policy initiatives. "This period will be the litmus test of the new government, and for asset allocators will be of vital significance," says Mr Schiessl. "If the DPJ gets it right, there are going to be an awful lot of people dusting off the 'How to invest in Japan' manual."

Mark Konyn, chief executive of RCM Asia Pacific, the active equity manager of Allianz Global Investors, says there are previous examples where the promise of reform spurred international investors to overweight Japan. This proved to be the catalyst for a sustained rally.

He says: "Fiscal spending restrictions and the ability for the government to access public debt markets remain a concern and Japanese government bonds are likely to come under pressure. Also, Japan's dependency on manufacturing cannot afford the yen at current levels and a catalyst for international investors would be a level change in the yen. This would make exporters more profitable and viable, and we therefore expect the yen to weaken towards the year-end. Further evidence of improving global demand would also be a catalyst for international investors to re-enter the market."

However, Pinakin Patel, client portfolio manager for JPMorgan Japanese Investment Trust and JPMorgan Fleming Japanese Smaller Investment Trust, warns: "The DPJ's agenda doesn't address any of the structural issues facing Japan that have caused caution and scepticism towards Japan among foreign investors."

Your choice of Japan funds

Japan funds may not appear in the lists of most popular selling funds. However, there are plenty of decent actively-managed funds that invest in Japan.

Open-ended funds

There are 51 funds in the Investment Management Association (IMA)'s Japan sector and seven in the Japanese Smaller Companies sector. For example, of the 51 funds in the IMA Japan sector, Morningstar gives 11 a top five-star rating.

The best performing open-ended fund of 2008 was the Neptune Japan Opportunities Fund which, despite dire market conditions, managed to deliver an unthinkable return of 82 per cent for the year. However, this astounding growth was largely due to fund manager Chris Taylor shorting the Japanese index, steering clear of financials and benefiting from a 71 per cent increase of the yen versus sterling.

However, for investors who were buying the fund because they wanted exposure to the Japanese market, the fund was not really doing what it said on the tin, because it was betting on the market going down. Had the Japanese market taken off, the fund would not have benefited from its short position on the index.

Other fund analysts pointed out that Mr Taylor's stock-picking record prior to 2008 was at best flat and volatile over some periods.

These are all things to consider when looking at performance tables. Neptune Japan Opportunities may be ranked top for performance among all Japan funds over one, three and five-year periods, but bear in mind that Mr Taylor took a substantial amount of risk in terms of the way he managed the fund, which paid off in 2008.

Other open-ended funds with top performance over the past five years are GLG Japan Core Alpha, Invesco Perpetual Japan and CF Morant Wright Japan.

Hargreaves Lansdown's Vantage fund supermarket recommends GLG Japan Core Alpha (see Fund Spotlight box), JPM Japan, Melchior Japan Advantage, and Schroder Tokyo in its Wealth 150 list of top funds. These funds are all in the IMA Japan sector.

Bestinvest gives Schroder Tokyo a top five-star rating, as does Morningstar. This fund, managed by Andrew Rose, aims to achieve capital appreciation through participation in the growth of the Japanese economy. Investment is based primarily on Japan's economic strengths, such as its manufacturing industry (in particular on those parts of it that are demonstrating an ability to exploit newly emerging technology) and on sectors benefiting from structural change in the economy. Contact www.schroders.co.uk for further information.

Top open-ended Japan funds

Source: Bestinvest using raw data supplied by Lipper. Notes: Figures show the value of £100 invested at the beginning of the 3 year period to 31 August 2009, bid to bid with income reinvested.

Investment trusts

Japanese investment trusts had a tough year in 2008, with all funds underperforming their respective benchmarks and lagging the equivalent open-ended peer group. Reasons for this included the use of gearing and being overweight in cyclical stocks, while underweight in utilities.

There are 10 Japanese investment trusts - five in the Association of Investment Companies' Japan sector and five in the Japanese Smaller Companies AIC sector. All of these are trading at substantial discounts to net asset value (NAV). In March, the Investors Chronicle , pointing out that performance had picked up following a review of the company's investment strategy in June 2008. The trust is still trading on a discount of 11.5 per cent.

There are also a number of exchange-traded funds (ETFs) that offer cheap exposure to the region.

Fund spotlight: GLG Japan Core Alpha

You may not have heard of the GLG Japan Core Alpha fund, but it is certainly one to consider for the strength of its manager's experience and his contrarian approach to investing in Japanese large caps.

Hargreaves Lansdown's Vantage Fund Supermarket singles the fund out as a 'core holding'. The fund also has a Superior rating from Morningstar and four stars from Bestinvest (five is its top ranking).

■ Get data, prices and charts for GLG Japan Core Alpha

The fund's manager, Stephen Harker, has over 30 years of investment experience, concentrating on the Japanese equity market since April 1984. At Prudential Portfolio managers (1983-93), he managed the Prudential Japanese Trust, a top performing mutual fund, as well as other Japanese equity portfolios.

In 1994, Mr Harker joined TCW London International where he continued to build a compelling track record as a contrarian/value investor. Following the acquisition of TCW in 2001, he joined SGAM UK where he has continued to manage Japanese equity portfolios for an established customer base. In January 2006, he and the Japanese equity team created the CoreAlpha strategy, which, within a short space of time, has grown to become an industry leading large cap Japanese equity product.

Bestinvest says: "The manager of this portfolio is expected to display a strong bias to 'value' style stocks, which he believes offer the best potential to outperform the Japanese market. The manager follows a mean reversion strategy where he sells stocks with high valuations in favour of lowly valued stocks. The portfolio can take an aggressive sector positioning as a result. Investors should note that in the past the manager's style has led to short periods of severe underperformance, although the long-term record is excellent. Mr Harker is expected to maintain a bias to larger companies, so the portfolio could underperform in periods when smaller companies rally."

However, he can still hold some exposure to small caps, which he used to his advantage at the end of 2008.

Mr Harker says: "The scale of panic last year was bigger than I'd seen in my whole career. So it led us to take a big bet on tech - brilliant companies that people were chucking out. We had built up tech positions since September and on 5 December the market turned in favour of tech."

The fund is now underweight tech and back to big again - he is currently overweight financials, retailers, telecoms and railways

"I've been investing in Japan for 25 years and the idea that you buy cheap stocks and sell expensive ones has worked for all but two years. I'm a natural contrarian."

He also points out that the price to book ratio of the Japanese stock market was at record lows in March. "It's above that level now, but to say the market is cheap would not be a jailable offence. If it was a stock we would be buying it."

The fund has a reasonable total expense ratio of 1.58 per cent and requires a minimum initial investment of £1,000.

For further details, visit www.glg.co.uk.

GLG Japan Core Alpha - top 10 holdings (as at end-July 2009)

Source: GLG