Bigging up Japan

David Prosser considers whether UK investors could benefit from more exposure to the world’s third largest economy.

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It is the world’s third largest economy, but it’s remarkable how often investors overlook Japan. While the case for international diversification is well understood – to mitigate risk as well as to support returns – investors in the UK often allocate a chunk of their portfolio to the US but completely ignore the next biggest advanced economy in the world.

Maybe that’s understandable. Europe, which features more often in the average investor’s portfolio, is closer to home. There is also a perception in the West that Japan is a bit of a basket case. Its economy has suffered well-documented structural problems for decades; its stock market hit an all-time peak in the late 1980s and has never reached such highs again.

However, as is pointed out in a recent note published by the investment companies analyst team at Kepler Trust Intelligence, Japan has delivered stronger returns than many investors realise. Over the ten years to the end of last year, Japanese equities delivered an average annual return of 9.2% in sterling terms; that didn’t quite match the gains racked up by the US market, but was ahead of the FTSE 100, the Euro STOXX 50 and the MSCI Emerging Markets indices.

Since then, moreover, Japanese equities have soared ahead. The Nikkei 225 Index is up around 27% this year, buoyed by a resilient Japanese economy and – more significantly – a shift in corporate culture in the country, with boards and directors finally responding to calls from shareholders to make governance changes and improve accountability. One enthusiastic investor in Japanese equities is Warren Buffett – the so-called “Sage of Omaha” revealed in April that he planned to increase his holdings in the country.

None of which is to suggest that investors should pile into Japan. The stock market has experienced several false dawns over the past 30 years, and Japan’s economy remains heavily exposed to the fortunes of the US and China. That said, some protection comes from Japan’s strong trade with other countries in East Asia, as well as the fact that many companies focus on the domestic economy rather than international trade.

However, for those investors who do think now could be a time to add Japanese equities to their diversification plans – or to increase holdings – the obvious question is how to do so. This is not a market in which most UK investors will feel comfortable investing directly, so a collective fund approach makes sense; in which case the dozen or so investment companies that specialise in Japan could offer some interesting opportunities.

For one thing, the long-term record of investment companies focused on Japan is superior to that of other types of collective funds. Japanese investment companies have consistently outperformed their open-ended counterparts – and by significant sums over longer periods.

Also, it is worth noting that despite the recent strong performance of Japanese equities, shares in many investment companies with exposure to Japan are still trading at generous discounts to the value of their underlying portfolio. In some cases, the discount currently runs into double figures.

The Kepler team point to several advantages of approaching Japan through an investment company, including the expertise and experience of teams in the sector and the active approach of their managers. It also points out that investment companies have the flexibility to invest in smaller companies as well as big stocks; indeed, a number of Japanese-focused investment companies specialise in this part of the market.

Trying to time any market is always a dangerous exercise – investment should be a long-term pursuit. But the bottom line is that for any investor looking to build a well-diversified portfolio of international stocks, Japan is well worth considering as part of the mix. This year’s hot streak is, if nothing else, a reminder of that.