Think Twice before Jumping into Japan

th around 20 percent loss in 2006. Optimists think now might be good time to weight towards Japan as downside risk is quite limited and unwinding Yen carry trade caused by liquidity crunch should be favorable to Japanese assets.

A strong correlation between Japanese Yen and world equity market has been observed this year: prices of both Yen and Japanese fixed income go up whenever market sentiment is bearish on the dollar. Average Japanese fixed income fund, the worst performing fixed income portfolio, shredded 1.88% last year while its performance improved greatly to one of top 10 performing fund categories, gaining 4.3% year to date and 6.5% over the trailing three-month period through Aug. 28.

However, Japan economy and equity market continue to fight their way out of a decade-long depression despite corporate earnings were good and latest unemployment rate fell to the lowest in over nine years in July. The Japan GDP growth rate lowered to 0.5% over the second quarter, dragged by export and consumer spending. This year Topix slumped 7.3% due to ongoing lack of investor confidence as well as economic weakness and uncertainty. Average Japan large-cap equity fund lost 4.37% and small/mid cap equity fund went down 8.75%.

The year-to-date performance of Japan small/mid cap equity funds varied greatly due to sector positioning. JF Japan OTC fund, one of the worst performing funds, was overweight in property stocks, which worked against its performance. Within the category, JF Japan Small Company (Yen) performed the best year to date through Aug 28 while Schroder ISF Japanese Equity Alpha has the highest three-year Sharpe ratio.

Investors should note that the Yen is quite volatile overall, despite unwinding yen carry trade could send the yen up against the USD if the US subprime meltdown continues. It is also difficult for mutual fund to capture short-term currency changes. In addition, both domestic and international economies are not supportive for Yen's appreciation. As liquidity dries up globally, Bank of Japan is less likely to tighten monetary policy, which should be supportive to yen carry traders. On the other hand, the strong yen coupled with a gloomy US economy outlook could further threaten Japanese exporter profits.

Lastly, small and mid cap stocks are more volatile than their larger peers. Investors tend to sell off small and mid caps whenever market conditions are not so rosy. It is unsound to predict Japan market has reached the bottom based on last year's slump. In fact, this year Japan equity funds continue to stumble although some investors expected they already hit the bottom at the end of last year. Moreover, some global and Asian equity funds already have exposure to Japan market. Even bold investors should not forget that pure or nearly pure exposure to Japan is a dangerous way to bet on resurgence here.