How To Pick A Product: Japanese Equities

Japan boasts the second largest equity market in the world, but is often overlooked – unsurprising when you consider that its stock market has clocked up more than a quarter of a century of losses: the Nikkei 225 stands at about half of its peak reached in 1989.

"Investors always talk about the lost decades; the country has been economically poor and the Nikkei 225 is still only around half its peak in the '80s," said Adam Laird, head of passive investments at Hargreaves Lansdown.

Prime minister Shinzo Abe brought much hope for economic recovery when he came to power in December 2012, but the country recently lapsed back into recession.

However, Adrian Lowcock, head of investing at Axa Wealth, believes it is a technical recession, not a crisis, and that Japanese equities "remain attractively valued", particularly following their sell-off during the summer.

But what is the best means of accessing this asset class? We weigh up the relative merits of traditional index trackers, exchange traded funds (ETFs), actively-managed mutual funds and investment trusts for investing in Japanese stocks.

Index Trackers

The Nikkei 225 might be the best known equity index in Japan, but it is "not a sensible index" for tracker funds, according to Laird. "It's calculated so that the companies with the highest share price (regardless of the size of the company itself) are the biggest in the index," he said.

Ben Yearsley, a director of Plymouth-based Shore Financial Planning, agrees, pointing to the torrid performance of the index as being "a great example of why not to invest in an index".

Laird believes other indices, like the TOPIX or the FTSE Japan, are a much better indicator of Japanese performance.

His favourite index tracker in the region is the BlackRock Japan Equity Tracker, which follows the FTSE Japan index of more than 450 Japanese companies and has low ongoing charges of 0.17 percent. "This is a straightforward fund from a reliable manager," said Laird.

ETFs

There are a couple of low-cost Japanese ETFs worthy of mention: iShares Core MSCI Japan UCITS ETF has ongoing charges of 0.2 percent and Vanguard FTSE Japan UCITS ETF of 0.19 percent.

A new, innovative index is providing greater diversity. The Nikkei 400 index covers 400 Japanese stocks that have been screened to meet certain accounting goals (such as profitability targets) and corporate governance measures (such as appointing non-executive directors).

"This has been popular in Japan itself: the Japanese government pension fund has bought into funds following this index," said Laird.

Yearsley also believes that Nikkei 400 ETFs could be worth a look. "The new Nikkei 400 focuses on companies that place shareholders at the forefront and that uses capital efficiently, so companies should be putting shareholders first – something that hasn't come naturally to many Japanese companies in the past," he said. "It is a grudging recommendation though; I'm not a great fan of any of Japan's indices."

Db X-trackers and Lyxor both have Nikkei 400 ETFs. Db X-trackers JPX-Nikkei 400 ETF is physically replicated and has ongoing charges of 0.2 percent, for example.

Investors who would want to hedge their exposure to the Japanese yen could consider the sterling hedged share class of Amundi ETF JPX-Nikkei 400 ETF, which uses synthetic replication and has ongoing charges of 0.18 percent.

"I wouldn't normally mention currency hedging, but it's important to consider in Japan," said Laird. "The Japanese yen is very strong, which is a risk to investors. If the currency weakens, it erodes returns, regardless of investment performance. Abe's government has indicated its intentions to weaken the yen; investors may want to protect themselves by buying a sterling hedged version."

Active Funds

Others believe that investing in Japan requires active fund management. "Investing in Japan requires a lot of patience and skill," said Lowcock. "The political climate has been stable for the first time in years, but with that has come a strong focus on getting the country growing again using stimulus and policy to fix Japan. As such, it needs an active approach to identify the right opportunities."

Darius McDermott, managing director of Chelsea Financial Services, is of the same mindset. "Japan is one developed market we would steer clear of in terms of passives: the market has had a diabolical couple of decades and you've made next to nothing, so you really need an actively-managed fund in this sector."

Man GLG Japan Core Alpha, run by Stephen Harker, is a perennial favourite. Harker is a contrarian investor, focusing on large, value stocks that are unloved by the rest of the market. The fund currently has a large exposure to Japanese banks.

Strategic Solutions likes Neptune Japan Opportunities, a high conviction fund which focuses on large, well-financed, industry-dominating Japanese multinationals.

James Oliver, a senior member of the Dorset-based adviser's investment committee, said: "We believe Japan is one of the biggest turnaround stories in the world today and it is these big multinationals, with their significant overseas exposure, that are likely to be the primary beneficiaries of yen weakness.

"[Manager] Chris Taylor has underperformed in the shorter-term, which is always a risk with a higher-conviction fund, but has done very well for our portfolios over the longer-term and we're a firm admirer of his approach."

The fund's yen exposure is hedged back to sterling, protecting equity gains against the protracted depreciation expected in the currency.

Investment Trusts

Despite Japan's economic woes, corporate profitability and margins are approaching record highs. "The improvements are not universal though and bottom-up stock-picking can make a real difference to returns," said James Carthew, research director at QuotedData. "The smaller companies area of the market is less well-researched so investment companies analysing this market can find hidden gems, while their closed-ended structure lets them be patient while the stocks re-rate."

Baillie Gifford Shin Nippon is Yearsley's favourite investment trust. "It is higher risk, as it invests in smaller companies, so you need to be patient with it, but over the long-term I would back it to outperform."

Smaller companies tend to be impacted more during times of market stress; small cap trusts are trading on larger discounts than their large cap counterparts at present.

The average discount in the Japan smaller company investment trust sector is 13.2 percent, compared to 6.4 percent in the Japan general sector, according to data from Winterflood Securities. Shin Nippon is on a 3.2 percent discount to net assets.