The biggest drop in sentiment among European fund selectors was for Japanese equities in the first quarter of the year when markets were in free fall.
Last Word Research found in a survey that sentiment for Japanese equities fared worse than for Asian and European equities (see chart below).
Source: Last Word Research
In Q1, sentiments among European fund selectors to buy Japanese equities in the next 12 months decreased (see chart below).
Source: Last Word Research
Sophia Li, portfolio manager at FSSA Investment Managers, explains that in Q1 investors were worried about the high number of Covid-19 cases in Japan.
The drop in sentiment could also stem from the cyclical nature of Japanese equities, she says, as these companies trade globally and have high overseas exposure.
“Given the deteriorating global economic outlook and trade friction between the US and China, investors are concerned about Japanese exporters and their increasing dependence on demand from China,” Li explains.
Nicola Takada Wood, portfolio adviser at RWC Partners, agrees, saying that the Japanese economy is tethered to the global economy.
She also suggests that the market sell-off provided investors with an opportunity to reallocate their stocks, exiting Japanese and entering US equities. The latter became more affordable and provided an opportunity to invest in quality and growth.
“Against a global backdrop of cheapening equity markets, Japan as a whole would have been viewed in a relatively negative light due to its low-growth outlook – being cheap is no longer enough,” she explains.
Japanese equity fund flows
The large drop in European investor sentiment for Japanese equities led to outflows from European domiciled funds, totaling $10.4bn (£8.3bn) from January to May 2020, according to data by EPFR Global.
Japanese domiciled funds, however, saw inflows of $38.3bn (£30.5bn), pointing to a contrarian trend among Japanese investors (see chart below).
Source: EPFR Global
Strategies of Japanese equity funds
To assess how Japanese equity funds have dealt with the negative sentiments by investors and outflows, Portfolio Adviser sister title Expert Investor spoke with the representatives of three funds: the Handelsbanken Japan Tema Fund, the RWC Nissay Japan Focus Fund and the First State Japan Equity Fund.
Handelsbanken Japan Tema fund
Staffan Lindfeldt is co-portfolio manager of the Handelsbanken Japan Tema fund alongside Ellinor Hult. Its institutional share class is a large-cap fund and has SEK4.3bn (£370m) in assets under management.
It performed +9.07% on average in the last three years.
As growth is arguably scarce in Japan, Lindfeldt explains that the fund is identifying companies through investment themes which focus on structural growth and are more or less independent from the economic cycle.
The fund seeks to outgrow the market sustainably through a “limited number of themes” and has benefitted from a long-term strategy, he says.
It also integrates environmental, social and governance (ESG) factors, which is an evolving trend in Japan and has further provided a tailwind for the fund, Lindfeldt adds.
Among other distinctive features of the fund are cooperation and critical exchange among the global portfolio managers.
“We believe that being an active part of the discussion and shared analysis of the group has been key to making better decisions in the portfolio,” he explains.
RWC Nissay Japan Focus Fund
Takada Wood is the portfolio adviser of the RWC Nissay Japan Focus Fund, which has delivered a cumulative return of -3.20% in the last three months and +31.43% in the last three years.
The fund, with ¥26.2bn (£190m) in assets under management, applies an ESG framework and has a focus on quality companies, which is in demand, says Takada Wood.
“We have never been investors in the typical companies of ‘Japan Inc.’, nor have we been proponents of Japan beta.
“We seek to find a select number of high-quality, resilient, growing companies, and engagement with management is at the core of our strategy,” she explains.
Resilience means companies “with high margins, dominant market share, customer loyalty, brand recognition, high barriers to entry, strong cash positions and management open to engagement”, she adds.
The fund also benefits from themes, such as innovative technology, digitisation or medtech, which were accelerated by the pandemic, and provided support over the past few months.
Takada Wood argues that Japanese companies have more experience than their global peers in weathering a protracted, low-growth environment.
“Some of the much-criticised characteristics of corporate Japan may now prove to serve them well,” she says, citing among others cash-richness, job security/lifetime employment and strong corporate relationships.
She also sees Covid-19 as an opportunity for change in Japan, supporting engagements with managers on topics, such as inefficiencies in cash flow management, factory operations, procurement and supply chains.
First State Japan Equity Fund
Li is the portfolio manager of the First State Japan Equity Fund, which is a flex-cap fund with $212.9m (£169.5m) in assets under management. It delivered, in cumulative performance, -1.1% in the last three months and +40.4% in the last three years.
She explains that the fund’s benchmark agnostic investment philosophy, long-duration growth and resilience in down markets have supported its long-term outperformance.
“Our fund has a high active share ratio of about 90% and only invests in quality companies that are able to generate sustainable profit growth and high return on investments without relying on either leverage or macro-economic factors,” she says.
Other factors that have helped the fund are, for example, its minimal exposure to purely cyclical companies with weak balance sheets; as well as its exposure to the digitalisation trend, including e-commerce and digital payments.
Li highlights that the performance of the fund’s holdings has decoupled from the Japanese equity market.
“Despite a number of long-term headwinds such as the challenge of an ageing population, anaemic GDP growth and low inflation, Japan offers a big investment universe in which a large number of companies have emerged with either strong global franchises or have learnt to keep inventing/innovating new products and business models to create new demand, without relying on the macro economy – [which] we call ‘self-help’.
“Investing in a selected number of high-quality Japanese companies is not equivalent to investing in the Japanese economy.”
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