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.

Japan Rally Boosts Japan-Heavy Fund
With that in mind, owners of funds with large Japan stakes naturally might have expected a bonanza. And that's what they received--if they own  Oakmark International (OAKIX). For years, that fund's lead manager, David Herro, has been one of the most vocal proponents of investment opportunities in Japan, as many others scoffed. That fund has roughly 25% of its assets in Japan, far more than most of its foreign large-cap peers, and it returned 21.1% over the three months through Feb. 12, nearly doubling the MSCI EAFE Index's gain and landing in the 1st percentile of the huge foreign large-blend category.

However, the size of Oakmark International's Japan stake alone doesn't explain that impressive result. More critically, some of the fund's biggest holdings were prominent Japanese exporters that investors thought would benefit especially well from the yen's drop. For example,  Toyota (TM) and  Honda (HMC), both in the portfolio's top-five holdings, climbed 35% and 28%, respectively, during the period.

Moreover, Herro has hedged a portion of the fund's exposure to the yen, helping to mitigate the ill effects of that currency's decline on the fund's returns. Because returns of U.S.-based funds are translated back into dollars, a falling foreign currency diminishes those returns--unless the position is hedged into dollars. Most international-stock funds don't hedge their exposure to the yen or any other foreign currency.

Hey, What Happened?
Further evidence that a high Japan stake won't automatically fuel chart-topping gains during a Japan rally can be found at  MFS International Value (MGIAX). That fund has about 25% of its stock assets in Japan, almost identical to Oakmark International's level. The managers of that fund already had been heavy in Japan prior to the devastating earthquake and tsunami in March 2011, but as Herro also did, they added more when stocks plummeted after those events. No matter: MFS International Value did not fare nearly as well over the three months in question as Oakmark International did. Its 10.4% gain was not only less than half of the Oakmark fund's return, but even lagged the MSCI EAFE Index and fell in the bottom quartile of the foreign large-value group.

One explanation is that the most prominent Japan stock in the MFS fund's portfolio--the top holding, in fact--is not an exporter that investors would see as an obvious beneficiary of a weaker yen, but KDDI, the Japan-focused mobile-phone and broadband firm. That stock actually was in the red over the three months. Another top-10 Japan holding, Kao Corp., fell sharply in late 2012 before rebounding this year.

The fund does hold smaller positions in Japan stocks that notched better returns, but overall, when one looks beyond the straight Japan weighting to the specific companies that MFS International Value owns, it's not surprising that its returns didn't get the boost one might otherwise have expected.

Two other international funds with large Japan stakes,  First Eagle Overseas (SGOVX) and  IVA International , also failed to light up the charts recently, despite having partly hedged their yen exposure. One reason: Like MFS International Value, their Japan stakes don't feature the big exporters garnering the most attention from global investors. Other aspects of the funds also weighed on results. Both funds employ cautious strategies, and their managers don't hesitate to leave money on the sidelines if they can't find compelling opportunities. At the end of October 2012--right before the Japan rally took off--First Eagle Overseas had 21% of its assets in cash and another 6% in gold bullion, allocations that dragged on returns. The cash and gold weightings at the IVA fund were similar.

The Big Picture
Many more funds could be examined, but a lesson emerges from these examples. Knowing a fund's portfolio can help explain results and, more importantly, set expectations for the future, but that knowledge has to go beyond the surface. Investors who choose an actively managed fund should do so because they trust that manager's judgment overall, based on track record, strategy, and other factors--not because it has certain sector or country weightings or simply lands in a certain portion of the Morningstar Style Box.

Approaching fund selection in that way means that investors who expect a certain portion of the markets to rally, and who select a fund on that basis, won't be unpleasantly surprised when the fund they thought would deliver on their bet fails to do so. In fact, even more-narrowly focused options that seemingly target the specific area or trend an investor wants to play can end up disappointing shareholders in that way. But that's a topic for another column.