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Think Twice Before Betting on Japan Funds

They may not be the value they appear to be.

William Samuel Rocco, 01/16/2007

It often makes sense to consider out-of-favor categories, and Japan funds were the worst-performing type of international offering in 2006, losing 2% on average, as their chosen market was the most sluggish in the developed world. What's more, many experts are optimistic about the Japanese economy, particularly with respect to exports to China and other Asian countries and corporate earnings and governance.

However, there are several reasons to think twice about buying Japan funds.

For starters, these funds aren't quite as downtrodden as they might first appear. Their 2006 losses were modest rather than marked in absolute terms. They didn't get the big currency bounce that most other overseas offerings received last year. (The U.S. dollar was relatively flat against the yen last year and thus currency didn't help or hurt returns of Japan funds; but the U.S. dollar weakened significantly against the euro and some other currencies and that weakness boosted the U.S.-dollar returns of funds with exposure to the latter currencies by quite a bit.) Further, Japan funds surged 33%--and outgained all other types of equity funds except for Latin America and natural-resources offerings--in 2005. They posted double-digit returns in 2004. Thus, they have 12% annualized gains over the past three years, which are pretty strong in absolute and historical terms--and better than those of many domestic-equity offerings--even if they're not as good of those of most other international-stock funds.

Meanwhile, the optimism about the Japanese economy is far from universal at present. Some experts are worried that the Bank of Japan might raise interest rates too soon and trigger the return of deflation, for example, while others are concerned about consumer spending and whether the new prime minister is as committed to economic reform as the last one was. In fact, the consensus view on the macro situation in Japan has switched back and forth between the glass being half full and glass being half empty a number of times during the past decade. And due to those changing perceptions, as well as some genuine problems and real risks, Japan funds have been more volatile than most other types of international-stock offerings over the shorter and longer terms.

Moreover, the vast majority of investors will find that they already have substantial exposure to Japan without adding a fund that focuses on that market. The average foreign large-cap fund devotes about 20% of its assets to Japan and several dozen such funds, including Longleaf Partners International LLINX and Putnam International Equity POVSX, have 25% or more of their assets invested there at present, so nearly all investors with core international holdings have sizable stakes in Japan. Individuals who own foreign small/mid-value or foreign small/mid-growth funds as their supplemental foreign holdings are taking on a significant amount of extra Japan exposure, because those funds also keep 20% of their assets in the land of rising sun. And there are more than 50 diversified U.S. stock funds with 5% or more of their assets invested in Japan currently, including such prominent funds as Dodge & Cox Stock DODGX and Third Avenue Value TAVFX.

Finally, investors 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. Most funds in the Japan category are pricey. (The typical no-load Japan fund is more expensive than the average no-load foreign large-cap offering, the typical no-load Europe fund, and the average no-load foreign small/mid-cap offering.) And many have manager-turnover or performance problems as well.

Meanwhile, even the most-attractive Japan offerings have their issues. IShares MSCI Japan Index EWJ and WisdomTree Japan Total Dividend DXJ are attractively priced and have other strengths, but these ETFs have pronounced blue-chip biases and thus overlap even more than most of their peers do with the Japanese portions of foreign large-cap holdings. The all-cap orientations of T. Rowe Price Japan PRJPX and Matthews Japan MJFOX lessen the overlap problem, and both have real promise as well as fetching expense ratios. However, the former enjoyed something of a headwind in Campbell Gunn's first few years and then lagged in 2006, and the latter has really struggled in the past two years.

In short, while there is real merit in considering beaten-up types of offerings, it's important to recognize that Japan funds have actually been solid performers in absolute terms in recent years, that their commitment to a single, challenging market comes with real issues, that most investors already have a lot of Japan exposure, and that many of the options have significant limitations.

William Samuel Rocco is a senior analyst with Morningstar.

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