Morningstar: "Think Twice Before Betting On Japan Funds"

William Samuel Rocco of Morningstar.com published a piece this morning that argues against having direct exposure Japan, or having more than you really need. I actually agree with a lot of what he says but have some additional insights.

My main point in response to his article is that it's too simple-minded and mistaken to consider Japan, both the world's second largest economy and capital market, to be fairly represented by any single fund. Granted, Rocco's target audience is likely primarily longer-term investors focused on mutual fund investing.

It's best I disclose up front that I'm not much of a believer in buy-and-hold and I'm not a big fan of mutual funds. Too many funds related to Japan offer nothing more than blue-chip exposure. On a market-cap basis that makes sense. However, you're missing out on a number of segments or investing/trading styles such as value, growth and smaller caps.

I definitely think having exposure to Japan is a necessity. However, I'm not sure having a 20% exposure from an international mutual fund, which is X% of one's overall portfolio, is enough.

Here are Rocco's main points with my comments italicized in brackets:

1. Japanese funds were down last year, the worst performing among the developed world and in Asia; however, on an absolute and historical basis, Japan funds have gained 12% (annualized) over the past three years.

[I agree that Japan was 'out-of-favor last year, but not exactly downtrodden.' Therefore, there's no real "dogs of the developed world" or "dogs of Asia" strategy other than my argument that compared to Asian emerging markets, a lagging Japan in '06 today offers investors quality stocks, a deep market and better transparency.]

2. Ambivalence over the strength of the Japanese economy.

[I agree, but ambivalence is the case for nearly every economy. Economists are always in disagreement. The strong points of Japan are robust corporate profits, improving balance sheets and commitment to R&D spending. The main areas of near-term concern include weak consumer spending, threat of a global slowdown and geopolitical risks (the latter two are things no country is really immune from).]

3. Volatility in Japanese stocks.

[Again, I agree and there's no denying this. I've written in the past and recently about volatility in the Nikkei that's unheard of in the U.S. While this is seemingly bad for "investors," I do see volatility lessening over time as Japanese institutional and individual investors increase shareholdings. Also, if you are trader, volatility is good!

Don't forget some of the volatility can be credited directly to foreign investors getting hyped and/or spooked and moving money in/out quickly in a short time period. Also, it's worth mentioning another risk, high correlation, where there have been times in recent years when Tokyo tracked the U.S. very closely (consider the impact of globalization and implications of monetary policy and consumer spending in Country X for Country Y).]

4. "[I]nvestors who are willing to take on the risks of a pure-Japan offering and want even more exposure to that market than they already have will find that they don't have a lot of terrific choices."

[Agreed. Given Japan's size and importance, you'd figure there'd be higher quality, lower-priced offerings. In fact, we're seeing an increase in ETF offerings and I expect the situation (fees, number of offerings, liquidity, etc) to improve. Do beware of unnecessarily high mutual fund expenses related to Japan pure plays. I am not thrilled about Japan mutual funds in general and do not like any particular fund at this time.]

4a. Blue-chip bias and overlap.

[Agreed and problematic, but unavoidable. My best advice if you are an "investor" and already have some Japan exposure via an international mutual fund and are looking for more: consider mid and smaller cap exposure. Two ETFs launched last year: WisdomTree Japan SmallCap Dividend (DFJ) and SPDR Russell/Nomura SmallCap Japan (JSC), should do the trick and you don't necessarily have to be concerned with their rather thin trading volume if your strategy is buy-and-hold.]

Lastly, Rocco commented a bit on forex. U.S. investors have not gained at all (calendar year basis in '05 and '06), and instead have lost some ground due to yen weakness. This is one area I see as a big plus to investing in Japan. The Bank of Japan is set to hike, perhaps as early as Thursday, but at least once in the first-half of '07 and likely once more by year end.

Going from 0.25% --> 0.75% is not game changing, but it does narrow the rate gap with the U.S., EU, etc. A stronger yen is like a dual sword, but I don't anticipate a turn in sentiment towards Japan's blue-chip exporters and would say yen-usd forex movements alone could result in an approximate 10% upside (or downside buffer) for Japan ADRs, ETFs and mutual funds in '07.

Recommended reading:

• Nomura's Individual Investor Survey for January

• Japan: A lot of Idle Cash 'Gradually' Flowing into Stocks

• Japan: 2006 Market Cap Ranking

• Japan: 2006 Year in Review, 2007 Outlook

Disclosure: I do not own a position in any stocks/funds mentioned above. My current exposure to Japan includes iShares MSCI Japan Index ETF (EWJ) call options, via proxy from Japan holdings in Dodge & Cox Int'l Stock (DODFX) and individual stock picks: Internet Initiative Japan (IIJI), NIS Group (NIS) and Sega Sammy (SGAMY.PK). I may be trading any of these (except DODFX) and other Japanese and Japan-related stocks at any given time.

Comments

[Lance:]

Re: Japan's volatility ...

Remember (or if anyone doesn't already know) that there is NO UPTICK RULE in Japan. Short on demand at the bid, baby.

Now ... yes ... and no laughing here, please ... they *did* institute, a few years ago, a provision that you can only short on demand 50 times the minimum trading unit in one order. So, if you want to swamp the system with shorts, you need to enter multiple orders. Real tough, that provision. Slightly mitigating, trading units have tended to drift toward 100s, from the 1000 shares that has been traditional for a long time, but there is still no uptick rule, and no rule against using computer technology to launch an avalanche of shorts.

This (lack of an uptick rule), and daily movement limits (you can find yourself up-limit or down-limit, trapped either way) make the TSE, in essence, exactly like a US futures market. These are precisely the attributes that make futures markets more volatile than equity markets -- in addition to greater leverage, which Tokyo also provides. (Margin is 33 percent, and you can borrow 80 percent against cash positions, so leverage is pretty darn good for equities.) Tokyo, or the people who run Tokyo, *love(s)* volatility. Of course they like it mainly on the upside, because that creates, rather than destroys, wealth.

But please understand, this is an insider's market run by "The Generals".

Volatility? I know Steven wants us to buy Internet Initiative Japan, and he may be right. But those of us who do have to stick our toes into a market that does a mere US$ 2 million a day on average. If somebody wants to unload a "real" position, you don't want to be long. It's simply impossible to manage risk in that small a puddle. What? I'm going to put US$ half a million in IIJ? My timing had better be *perfect*.

Finally, MUFG is said to be stronly considering a 10-for-1 stock split this fall. What this does, of course, is put TEN TIMES the amount of shares out there that can be borrowed for shorting. Recently, there has been scandal after scandal over enormous stock splits. If MUFG should run up before the split date, I would exercise *extreme* caution.

I know that MUFG wants to increase their individual shareholders ... but take care, they may not exactly care (guaranteed, actually, that they don't) if *you* get blown out in the long term process of that transformation.

2007 Jan 17 03:35 AM