Think Twice Before Betting On Japan Funds

It often makes sense to consider out-of-favor categories, and Japan funds were the worst-performing type of international offering in 2006: Japan Equity Funds lose 0.13% ....

William Samuel Rocco 22 January, 2007 | 0:00
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It often makes sense to consider out-of-favor categories, and Japan funds were the worst-performing type of international offering in 2006: Japan Equity Funds lose 0.13% on average, and Japan Small/Mid Cap Equity Fund lose 20.77% on average, as their chosen market was the most sluggish in the developed world. What's more, many experts are optimistic about the Japanese economy, particularly with respect to exports to China and other Asian countries and corporate earnings and governance.

However, there are several reasons to think twice about buying Japan funds. For starters, these funds aren't quite as downtrodden as they might first appear. Their 2006 losses were modest rather than marked in absolute terms. T

hey didn't get the big currency bounce that most other overseas offerings received last year. (The U.S. dollar was relatively flat against the yen last year and thus currency didn't help or hurt returns of Japan funds; but the U.S. dollar weakened significantly against the euro and some other currencies and that weakness boosted the U.S.-dollar returns of funds with exposure to the latter currencies by quite a bit.)

Further, Japan equity funds and Japan small/mid cap equity funds surged 27.81% and 36.72% respectively--and outgained many other types of equity fund offerings--in 2005, and they posted double-digit returns in 2004. Thus, they have 12.82% annualized gains over the past three years, which are pretty strong in absolute and historical terms--and better than those of many domestic-equity offerings--even if they're not as good of those of most other international-stock funds.

Meanwhile, the optimism about the Japanese economy is far from universal at present. Some experts are worried that the Bank of Japan might raise interest rates too soon and trigger the return of deflation, for example, while others are concerned about consumer spending and whether the new prime minister is as committed to economic reform as the last one was. In fact, the consensus view on the macro situation in Japan has switched back and forth between the glass being half full and glass being half empty a number of times during the past decade. And due to those changing perceptions, as well as some genuine problems and real risks, Japan funds have been more volatile than most other types of international-stock offerings over the shorter and longer terms.

Moreover, the vast majority of investors will find that they already have substantial exposure to Japan without adding a fund that focuses on that market. Many Global Equity funds devote large pieces of their assets to Japan and several dozen such funds, including Investec GSF –Global Strategic Equity Fund and Fidelity Funds-Consumer Industries, which now have 10.62% and 12.13% of their assets invested there respectively at present, so many investors with core Global holdings have sizable stakes in Japan. And there are more than 50 diversified U.S. stock funds with 5% or more of their assets invested in Japan currently.

Meanwhile, even the most-attractive Japan offerings in US have their issues. IShares MSCI Japan Index (EWJ) and WisdomTree Japan Total Dividend (DXJ) are attractively priced and have other strengths, but these ETFs have pronounced blue-chip biases and thus overlap even more than most of their peers do with the Japanese portions of foreign large-cap holdings. The all-cap orientations of T. Rowe Price Japan PRJPX and Matthews Japan MJFOX lessen the overlap problem, and both have real promise as well as fetching expense ratios.

In short, while there is real merit in considering beaten-up types of offerings, it's important to recognize that Japan funds have actually been solid performers in absolute terms in recent years, that their commitment to a single, challenging market comes with real issues, that most investors already have a lot of Japan exposure, and that many of the options have significant limitations.

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About Author

William Samuel Rocco  William Samuel Rocco is a senior fund analyst with Morningstar. He would like to hear from you, but he cannot provide individual-portfolio or financial-planning advice.

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