The Japan Rally's Effect on Mutual Funds

In recent months, Japan's stock market has been a star.

In mid-November, the evidence began to mount that Shinzo Abe, a former prime minister, would win that country's election in December and implement financial and economic reforms, most notably efforts to weaken the yen. In response, the Japanese stock market soared.

For the three months through Feb. 12, 2013, the MSCI Japan Index rose 24.8% in local-currency terms, far more than any other developed market. In second and third places lie Greece and Portugal, buoyed by the perception that they've weathered the worst of their crises; they notched gains of 15% and 16% in their respective MSCI Indexes. The major European markets were even further behind: the United Kingdom, Germany, and France managed only single-digit gains. (The U.S. market was in that range as well.)

It seems logical that international funds with notably large stakes in Japanese stocks would benefit the most from this trend--and in some cases that occurred. But there was no guarantee. In fact, a variety of funds with outsized stakes in Japanese equities have lagged, relative to their rivals, despite the success of that country's stock market. 

This phenomenon is worth a closer look. Not because the rally is necessarily destined to last: For all we know, it could fizzle quickly and be forgotten by the time 2014 rolls around. And of course, short-term returns are usually not worthy of emphasis.

But in this case, the short-term (for now) underperformance of certain funds merits examination, for it demonstrates the difficulty of forecasting fund results based solely on individual country or sector weightings or other similarly broad measures. This idea applies to long-term performance, as well. Investors who appreciate that have a better chance of avoiding unpleasant surprises when funds don't perform as expected.   

Politician Speaks, Market Reacts
A few weeks before December's elections in Japan, it became clear that Shinzo Abe would likely be returning to the prime minister's office. Markets reacted decisively. The main reason was that Abe indicated that he would take action to weaken the yen. That sent the yen--which had been hovering near historic highs--tumbling. And because the yen's strength had been among the factors damping sentiment for Japanese stocks (particularly the big exporters), the stock market rose sharply as well.

Those trends continued as Abe's election became reality in December and into 2013, though though the sharpest moves occurred prior to the new year. As noted above, by the middle of last week Japan's three-month stock market surge had far surpassed the more modest rallies posted by other developed markets. In fact, Japan's gain easily topped those of all emerging markets, too. For good reason, the sinking yen and booming Japanese stock market became big news in the financial world.