Japan equities best placed to outperform say fund managers

Fund managers are united in expecting Japan to outperform other developed markets, according to Standard & Poor’s Fund Services latest update on the sector.

Alison Cratchley, S&P Fund Services analyst, explained that there are two main reasons for this upbeat view. First, the Japanese financial system has nothing like the same exposure to global credit problems as major Western economies, especially the US and the UK.

“Both Japanese companies and households have strong balance sheets,” said Cratchley, citing IFDC manager Albert Abehsera’s estimate that the total exposure of corporate Japan to toxic loans is no more than US$15bn.

A second reason for optimism is that Japan has simply been underperforming for so long that valuations are now more compelling. Fund managers interviewed by S&P Fund Services pointed out that Japan is attractive on a number of valuation metrics, including P/E ratio, yield, return on equity and debt to equity.

The fund managers’ optimism comes after a bleak quarter in which investors in Japanese equity funds lost more money than the S&P Japan market indices.

“No S&P rated fund delivered a positive return in the three months to the end of August 2008,” said S&P Fund Services’ Cratchley, pointing out that the median fund in the S&P Japan mainstream equities sector lost 13.1% over the quarter, bringing its year-to-date loss to 17.8%. This compared with losses of 11% and 14.2% for the S&P Japan 500 index. The median small- and mid-cap fund was down 12.1% over the three months and fell 21.1% in the year to date, against 11.8% and 14.2% falls for the S&P Japan SmallCap 250. (All figures are in yen).

S&P found the main reason for poor performance, even by highly rated funds, was incorrect sector positioning. There was extreme divergence of returns among sectors, with the leaders being defensives such as utilities, healthcare and telecoms and the laggards being cyclicals, with significant losses such as in financials, materials, industrials and IT.

“Without exception, the underperforming funds we reviewed were overweight in cyclicals and underweight in defensives,” said Cratchley, mentioning the example of the S&P AAA rated IFDC Japan Dynamic Fund and the UBAM IFDC Japan Equity Fund, where manager Albert Abehsera attributed his funds’ underperformance to their overweight in IT and underweight in electric power & gas. Meanwhile, Joji Maki of the S&P AA rated Baring Japan Growth Trust was similarly hit by underweighting electric power & gas and pharmaceuticals and overweighting machinery.