The Best Ways to Respond to Japan's Resurgence

When Japan's economy revives and its stock market climbs, people take notice. That's not surprising: Despite more than a decade of sluggish growth mixed in with the occasional recession, Japan remains one of the world's biggest economies. And any stock market that's still more than two thirds below its all-time high must seem like it has enormous potential. (That the all-time record might have been ridiculously steep is another issue.)

That background explains why media attention has focused on that country recently, and why foreign investors have been pouring money into its stocks (conveniently pushing the prices up further). On the mutual fund front, the Japan-stock group--despite its small size--was eighth-most popular of the more than 50 Morningstar categories as far as inflows in September 2005, according to the Financial Research Corporation. That put it ahead of the much bigger and typically much more popular foreign large-value and foreign large-growth categories--as well as every domestic-stock category.

This is not just a one-month phenomenon, either, as a look at one particular fund illustrates.  Fidelity Japan Smaller Companies (FJSCX), which had $361 million in assets at the end of 2002, has grown sharply and steadily since then, to the point where it had $1.34 billion under management at the end of September 2005. (Some of that rise owed to market appreciation, but the bulk came from inflows.)

We're not going to try to predict whether this is the right time to invest in Japan. After all, even some of the most astute investment minds can't get global macroeconomic calls right with any degree of consistency. And Japan's market has enjoyed other rallies in recent years that ended badly, with the index right back where it started--or lower. But for the most part, the international-fund portfolio managers we speak with are encouraged by the situation. (Note that we're referring here to managers of broad foreign funds that can invest anywhere--examples include the managers of  T. Rowe Price International Stock (PRITX),  Vanguard International Growth (VWIGX), and  Fidelity International Discovery  (FIGRX)--rather than Japan-only managers who might have a bias toward that market.)

While past rallies have been based largely on hope, they say, now there is solid evidence that many Japanese companies have taken concrete steps to address their structural problems and old-line attitudes that were holding them back, and will continue to do so. They also think the general economic structure is in better shape than it has been in years. The once-horrendous banking sector, for instance, has made important strides toward attaining a sound footing.

So if you buy that argument, what's the best way to take advantage? Unfortunately, this rather compact category--unlike the broader international groupings--doesn't boast any truly outstanding choices. But it does contain a few funds that can adequately meet your needs if you're interested in putting some money in that market. Just remember: We're not recommending that you do jump in, and we caution you that if you do, don't overdo it. After all, if you own a broad foreign-stock fund (or several), it's almost certain they have significant Japan stakes themselves. In fact, given that situation, we think owning one of the better choices of that variety will give you plenty of Japan exposure without adding a specialist fund. But if you've decided to go that route, here's some insight into some of the more reasonable choices.

 T. Rowe Price Japan (PRJPX)
This once-mediocre offering has perked up under the guidance of Campbell Gunn, who took over as lead manager in early 2003. He changed the fund into more of an all-cap vehicle, and we tend to prefer those in a Japan fund. Not only does that approach ensure you won't be shut out of whichever market cap segment happens to be leading at any one time, but it also gives you companies besides the household names likely to be featured in broader international funds you may own.

 Matthews Japan (MJFOX)
This one also takes an all-cap approach. It's having a dismal 2005, but its longer-term record is impressive. Moreover, the Matthews shop generally treats fund shareholders well and concentrated its efforts on building an expertise in Asia over many years rather than trying to be everything to everyone. Its other funds are also fine performers. This one's expense ratio was once unpleasantly high but has been falling recently.

 Fidelity Japan (FJPNX)
Though not a stellar performer, this fund does have a decent record and is unlikely to disappoint too seriously even if its returns don't stand out. Its main attributes are a manager who has been in charge for five years, much longer than typical in this category, and an expense ratio that's very reasonable for an actively managed offering in a specialized category.

 iShares MSCI Japan Index (EWJ) and  iShares S&P/TOPIX 150 Index (ITF)
As exchange-traded offerings, these choices are bought and sold differently than conventional mutual funds. But if you're not planning to make frequent trades, the commission expenses won't take too big a bite, and their expense ratios are much lower than those of regular Japan mutual funds. Be aware, though, that both are large-cap vehicles with very little exposure to smaller companies. As a result, of the funds on this list, their holdings are most likely to overlap with those you own in broader international funds. The Topix fund is a bit cheaper, but it's even more focused on the giants, and for larger investors, it's worth noting that the Topix fund's shares don't trade nearly as often as those of the MSCI Japan Index fund; the latter is one of the most heavily traded ETFs around.

Two other funds require a mention because of their returns and, in one case, popularity, even though we hesitate to suggest owning them.  DFA Japanese Small Company (DFJSX) has topped the performance charts frequently in recent years with a passive approach that focuses on value-priced, tiny companies. It has benefited as small caps in general have led the Japanese market and its particular holdings have shined. But the fund's very narrow focus and a very high minimum investment limit its appeal. Meanwhile, as mentioned above, Fidelity Japan Smaller Companies has garnered plenty of inflows, and its returns have also been bolstered by the small-cap surge. But again, if you're already targeting a narrow area by choosing a fund focused on just one country, you may want to think twice before narrowing further by choosing only the smallest firms in that country.