After decades of disappointments following the 1990 market crash, Japanese equities have returned an astonishing 82% in Yen terms over the last 15 months. Many commentators believe such a rally is a false dawn given there have been approximately five rallies of over 40% in the last 20 years with all subsequently disappointing, driven by a mixture of political instability, low economic growth, persistent deflation and geological events.
Japan now ranks as one of the best performing major developed equity markets
In that environment, active managers have struggled to deliver consistent returns as specific styles have alternatively performed strongly and subsequently often mean-reverted.
Most commentators have notoriously reported over the years how difficult it is to make money in Japan and indeed as 2012 progressed, most investors seemed to have given up on Japan. A few months later, Japan now ranks as one of the best performing major developed equity markets globally.
Unsurprisingly, the overweight to Japan is a consensus position in the latest BofAML Global Fund Manager Survey and, in terms of asset flows, Japan was the number one destination for equity flows in 2013 according to Deutsche Bank's Weekly Fund Flows and fund flow trends data.
Although past performance is not a guide to future performance, the recent stellar returns from Japanese equities seem to have served as a wake-up call for many investors. In 2013, the Topix index produced a 55% total return in Yen terms. However, for foreign investors much of these gains were eaten away by the Yen’s weakness against major developed currencies.
Whilst the sceptics will say that this could be another false start for Japan, there have clearly been fundamental improvements which have led investors to revisit their stance on Japanese equities. New Prime Minister Shinzo Abe has adopted a comprehensive economic agenda of ridding deflation and increasing nominal GDP by undertaking a policy of 1) expansive monetary easing; 2) fiscal restructuring; and 3) adopting structural reforms including on the corporate side to raise nominal wages.
These three policies have been termed the 'three arrows' of Abenomics, and with reduced policy volatility due to a politically-dominant Abe working in tandem with the Bank of Japan (BoJ), they have provided the most optimistic environment to end Japan's two lost decades.
One of the objectives of Abe is to end 20 years of deflation and in reflating the economy the depreciation of the Yen becomes crucial. As things stand, the Japanese economy is set to grow well above-trend rates at least through 2015, despite the upcoming major fiscal contraction via a consumption tax rise. The BoJ is also likely to take additional easing measures in the first half of 2014, partly to mitigate the negative effects of the tax hike, but also to help achieve its inflation target as upward price pressures ease. This should ensure that monetary policy, the “first arrow” of Abenomics, continues to be supportive.
The fact that the recovery is based on the most comprehensive and unified economic policy changes Japan has experienced in several decades leads us to believe it is materially more likely to be sustained than past “false starts”. While there are risks in the short term, we are thus optimistic for Japanese equities over the long run. As was the case last year, hedged exposures are preferred (at least partially) as a need to manage potential currency volatility and further yen depreciation. That said, we observe that investors/speculators are already very short the Yen, so the scale of the depreciation from here is likely to be less than in 2013.
Given the above trend, it is therefore unsurprising that ETF providers have launched a raft of hedged share classes in the last 12-18 months, as these have highly popular choices for investors. Previously, international investors could only really opt for euro-hedged share classes but the most recent trend has been the launch of GBP, USD and CHF-hedged share classes from major players such as iShares, Deutsche Bank, Lyxor and UBS.
On the active side, and as can be expected given the tough environment Japanese equities have faced in the last two decades, there have not been many fund launches in the last few years. The largest players have attracted the bulk of the flows, such as GLG Japan CoreAlpha (
Gold rated) and Polar Capital Japan (Silver rated) both of which have limited remaining capacity. Among Schroders’ range of Japanese equity funds, Schroder ISF Japanese Equity also remains one of the largest players in the sector. These three funds provide investors with different approaches, characteristics and return profiles. GLG Japan CoreAlpha invests predominantly in large cap equities using a deep value contrarian bottom-up approach. Polar Capital Japan combines top-down and bottom-up inputs in an all-cap portfolio. Schroder ISF Japanese Equity is a predominantly bottom-up growth-at-a-reasonable-price (GARP) type of fund.
It is well documented that historically value investing in Japan has led to outperformance in 80% of the last 30 calendar years. The performance differential between growth and value has been over 10% a third of the time, and when one breaks the growth and value indices by market cap- large, mid and small, 85% of the time performance differentials were greater than 10%. Whilst selecting managers with a value style has historically been rewarded in Japan over the long run, timing often matters and for investors unwilling to make directional bets on the Japanese equity market, blending different styles and approaches can be a good way to get exposure to Japan.
