Japan Is Hot. Here Are the Best Funds to Play It.

The various catalysts driving Japanese stocks include a view that the country is fixing its longtime deflation woes, improving corporate governance, and growing more shareholder-friendly through a series of structural reforms over the past decade. And there is hope that the Bank of Japan will soon become less restrictive in keeping a lid on bond yields, making Japanese assets even more attractive.

For all of those reasons and more, this looks like a good time for U.S. fund investors to consider increasing their exposure to Japan. 

Although U.S. investors can buy American depositary receipts of Japanese companies, mutual funds can offer more convenience and diversification than individual stocks do. 

“It’s been happening for some time now, but the pace of change really started to pick up” in 2023, says Drew Edwards, a portfolio manager and head of Japan value equites at GMO. “It’s still a pretty cheap market,” says Russ Koesterich, a portfolio manager of the
BlackRock Global Allocation
fund. “A lot of names in Japan still score very well in terms of their valuation, particularly compared with the U.S.”  

Shuntaro Takeuchi, a manager of the
Matthews Japan
fund, notes that the
MSCI Japan Index
trades at 14.6 times forward 12-month earnings, in the middle of its range for the past 10 years. Another encouraging sign, he says, is that “Japan’s dividends and buybacks have been steadily improving over the decade, but still lag behind other developed markets.” 

There are different ways for U.S. fund investors to play Japan. One option is international funds that have a broader focus, such as the $123 billion
Vanguard FTSE Developed Markets
exchange-traded fund. Japan was the portfolio’s largest country weighting, at 22%, as of Sept. 30. Investors, however, can drill down further by using various Japan-focused funds, both active and passive.

Morningstar
recently supplied Barron’s with a list of 26 open-end Japan stock funds, 11 of which are actively managed. The rest are index funds.

The largest is the $14 billion
iShares MSCI Japan
ETF, which covers roughly 85% of the Japanese stock market, according to Zachary Evens, a Morningstar research analyst.

“It’s not the entire universe, but it’s a pretty full representation of the Japanese stock market,” he says. The fund’s holdings include
Toyota Motor,

Sony Group,

Mitsubishi UFJ Financial Group,
and
Hitachi.

The iShares MSCI Japan ETF and several other large index funds have captured the lion’s share of fund flows recently. The iShares ETF alone raked in about $2.7 billion on a net basis over the 12-month period ended Nov. 30, according to Morningstar. 

Kristy Akullian, a senior investment strategist at iShares, a unit of BlackRock, says the ETF “is very much used by the retail investors, and heavily traded by institutional ones.” 

Many of the actively managed Japan funds tracked by Morningstar, however, have had outflows, even after a good stretch for Japanese stocks.

Investors “definitely prefer passive, and they definitely prefer lower-cost,” says Evens.

The iShares ETF that tracks the broad Japanese stock market sports an expense ratio of 0.50%, compared with around 1% for many of the actively managed portfolios in this category. 

Another big consideration for U.S. investors is whether to pick a fund that hedges currency risk.

The Nikkei 225 returned 31% last year in local currency. That was well ahead of the 22% result in U.S. dollars.

The yen slid to a multidecade low against the greenback in mid-November. That currency, however, has regained some ground as traders have factored in the increased likelihood of a rate increase by the Bank of Japan, while the Federal Reserve is likely to cut rates this year. (The yen did weaken a bit following the Jan. 1 earthquake on Japan’s west coast.)

Evens says two crucial considerations are whether a fund hedges and the length of an investing time horizon. “The longer the time horizon, the less effect exchange rates will have on the overall performance of the fund,” he says.

The
iShares Currency Hedged MSCI Japan
ETF is very similar to iShares MSCI Japan, but it hedges, as its moniker suggests. With assets under management of around $200 million, it’s tiny compared with its much larger sister fund. 

But the hedged version has had much better performance over the past half-decade. Its five-year annual return is 14.5%, well ahead of the 6.6% result for the unhedged version. Both funds have the same expense ratio of 0.50%.

“I’m a little bit puzzled by the lack of assets in the hedged version relative to the unhedged version, because typically flows follow performance,” says Evens.

Instead, the hedged version had net outflows of about $2.7 million during the 12 months ended Nov. 30.

Akullian of iShares says she doesn’t believe “most retail investors think about currency as much in international exposure” and that “looking across all international exposures, we see a lot more money going into unhedged than hedged.”

Of the 26 Japan funds that Morningstar tracks, only four actually hedge.

Matthews Japan, which is actively managed, doesn’t hedge. With about $640 million under management, it’s the largest fund by assets among the actively managed Japan-focused portfolios, according to Morningstar.

“My job is to invest in the companies that can provide good investment results—not call the currency,” says Takeuchi, one of the fund’s managers.

The fund returned about 18% in 2023, including dividends. Its five-year annual return of 6.5% ranks in the top half of Morningstar’s Japan stock category.

Takeuchi observes that investors sometimes overlook the country’s stock returns over the past decade.

He points out that from the beginning of 2014 through Nov. 30, the MSCI Japan Index had an annual return of 4.9%, compared with 4.2% for the comparable index for Europe and 2.6% for emerging markets. The S&P 500 returned 11.6% annualized over that period.

Change is certainly in the air in Japan, and U.S. fund investors have plenty of options to at least nibble.

“There’s actually good interest in Japan, because investors are always looking at change and the potential for change,” says Simon Fennell, a portfolio manager at William Blair and longtime investor in Japan.

Write to [email protected]