Time to go big in Japan?

Are financial advisers allocating enough of their clients’ portfolios to Japanese equities? It is often overlooked that Japan is the world’s second largest stock market, accounting for around 5.6% of the FTSE All-Index World Index – around one-and-a-half times as much as the UK market. Yet Japanese equities have been routinely shunned by advisers and investors alike.

There are some good reasons for that. For much of the past 35 years – since the Japanese market peaks of the late 1980s in fact – the country’s stock market has struggled to make progress. During a prolonged period of economic malaise, financial crises and political upheaval, hopes for a recovery from Japanese equities were repeatedly dashed.

Today, however, something has changed, as analysis just published by the investment trust team at Kepler Trust Intelligence points out. As Kepler explains, February 2024 saw the Japanese stock market finally break through its 1989 record high, moving well ahead of that level by the summer. Performance has been more lacklustre since then, but that has also been true of most major global markets.

Why should we think this is not just another false dawn? Well, there are a number of reasons to be positive. Japan remains the world’s fourth largest economy, after all, and is particularly strong in fashionable areas of the market including technology. Blue-chip companies such as Sony, Nintendo and Uniqlo have global appeal. And the country’s manufacturers are benefitting from the trend in the West for companies to reduce their reliance on Chinese exports.

Importantly, points out Kepler, Japan has also embraced corporate governance reform in recent years. For a long time, Japan was seen as anti-shareholder, with many companies employing tactics to limit investors’ influence, such as maintaining large cross-shareholdings in one another. Dividend payments were disappointing. The threat of a takeover – often a catalyst for Western companies to focus on shareholder returns – was non-existent.

More recently, however, Japanese regulators have introduced a range of new rules designed to tackle some of these problems. Companies are increasingly required to appoint independent board directors. They must be much more transparent about crossholdings. Share buybacks and special dividends have become far more common. These changes are an important part of the reason for Japanese equities beginning to post decent returns once more.

How, then, to increase exposure to Japan’s stock market? Well, investment trusts’ track record in the country is certainly strong. Data published in the Spotlight newsletter produced by the Association of Investment Companies (AIC), analysed 241 rolling 10-year periods over the past three decades. It revealed that Japan-focused investment trusts outperformed comparable open-ended funds in more than six in 10 of those periods.

Kepler also believes Japanese-focused investment trusts are a sensible vehicle through which to approach the Japanese market. Collective funds provide diversified exposure to Japanese equities with competitive costs and the promise of liquidity, courtesy of daily dealing, the analyst points out.

Investment trusts have a particular advantage in Japan, Kepler argues, because their closed-ended structure makes it easier for them to invest in small and medium-sized companies. This is where many of the best opportunities in the Japanese stock market are to be found, it says.

Is it time for advisers to reposition investors’ portfolios? Well, that will naturally depend on individual clients’ appetite for risk, their investment objectives and time horizons, and their current exposures. But most advisers will have large numbers of clients with portfolios that don’t come near to reflecting the weightings of Japanese equities in global indices. Now may be the time to begin closing the gap.