From the September 2002 issue of Investment Advisor • Subscribe!

September 1, 2002

Japan Ink

Find the very idea of investing in Japan inscrutab

Mention Japan to a crowd of clients, and you'll wind up in a room with plenty of emptied chairs. Yet, despite this recent most volatile U.S. market, and the second-worst bear market of the last century, it's not all bad news. Take Japan's market. True, the large-cap Nikkei 225 index has basically tracked the S&P 500's own slippery slope. But it's also true that among small- and mid-cap Japanese companies, against-the-grain profits have been made. In this column, we'll see whether or not bottom-fishing Japanese blue chips makes sense. And we'll talk with a manager who is inarguably one of the best and brightest at spotlighting companies many of us will never do business with, but that form a staple diet for Japanese and Asian consumers--a diet rich in earnings and potential. We'll also travel a road most of us have tried to wend without being upended en route, accounting for analysts' ability (or lack thereof) to steer us in the right direction. First up, the other blue chips.

Unlike some things, when a country's stock market has been going downhill for a dozen years, that doesn't make it over the hill; that makes it cheap. And with respect to established markets and economies, cheap can also spell opportunity.

Of course, Japan's market has been getting cheaper and cheaper over the past decade, making our bear look like a cuddly guinea pig. The Nikkei index is still selling for a quarter of its peak at the end of the 1980s. (And like the U.S. market, it's down about 50% from its more recent peak in the spring of 2000.) As with any market, no one can guarantee it's going up from here, but you are guaranteed to be four times better off than the masses of investors who were piling in a dozen years ago. Back then, Japan could do no wrong in its rather centralized business, political, and financial dealings, but the 1990s were all about new technologies, new management, and (ahem) transparent accounting; none were unkind to stodgy, centralized decision-making.

Now Japan realizes that it has big decisions to make in all the major public policy areas: fiscal (taxes and spending; e.g., are more underused roads the best way to a Keynesian stimulus?), monetary (how low can interest rates go?), and banking (to what extent can banks be allowed to fail, and should depositors be limited to a 10-million-yen guarantee, just as American bank deposits have generally been guaranteed only up to $100,000?).

For the last dozen years plus, anti-reform politicians and bureaucrats have obstructed most changes to Japan's previously comfortable status quo; the question now is whether Prime Minister Koizumi can impose reforms, which mostly depends on whether public disgust outweighs fear of change. As with the U.S., everyone opposes "waste, fraud, and abuse" (as Reagan called it), but every program and policy has entrenched defenders. (Japan's most recent consensus does seem to favor less spending on roads and bridges, but more on the elderly.)

Naturally, virtually everyone who wants to invest in Japan is going to want a diversified investment, like a Japan-focused mutual fund. Unless a client has a multimillion-dollar portfolio and wants to put more than, say, 10% of assets in Japan, it's hard to justify the focus needed to analyze a suitable diversified portfolio of individual Japanese stocks. While, for example, the Japan Times (www.japantimes.co.jp) is available online in English and has good business coverage, it certainly is harder to analyze more obscure Japanese firms. Further, there are several good Japan-only mutual funds to choose from, with solid options from Fidelity, Vanguard, T. Rowe Price, Morgan Stanley, and Goldman Sachs.

Another option familiar to regular readers of this column and especially suited for minimizing taxable distributions (but not unsuited to retirement accounts, either), is the exchange-traded fund (ETF). ETFs trade like stocks with no loads (just regular stock-like commissions), and lower expenses and distributions than can be found in just about any mutual fund. As we've noted before, often the advantages of indexing are considerable in large-cap, more efficient markets, while a well-chosen managed fund often makes sense in less efficient and/or smaller-cap markets. And so this month we're casting two nets, one a large-cap Japan ETF, and complementing it with the actively managed Fidelity Japan Smaller Companies fund (see interview at right with the fund's manager).

Japan ETFs

There are two large-cap exchange-traded funds that hold only Japanese stocks. Our choice, the iShares S&P/TOPIX 150 Index Fund (ITF), tracks, essentially, the largest 150 Japanese stocks with approximately market-cap weightings.

While the TOPIX fund only dates back to October 2001, and has recently had a market cap of just $30 million to $40 million, that's not really a drawback for an ETF. The structure of ETFs means new shares can be created or eliminated to meet just about any market demand, so liquidity should not be a problem. (We also expect the newer fund to grow as it gets a bit older.)

While the more established (March 1996 inception) iShares MSCI Japan Index Fund (EWJ) tracks almost 300 stocks, is about 10 times as large, and has almost a thousand times the trading volume of the TOPIX fund, the newer, smaller TOPIX fund actually has a lower expense ratio (0.50% vs. 0.84%), in part due to its shorter stock market "tail."

Further, the two funds are not as different as their stock counts (150 stocks vs. 285 stocks) might make them appear. A long stock "tail" is usually not a major determinant of an index's holdings or returns. And in fact, a full 88% of the MSCI Japan ETF's assets are found in its top 150 holdings. Further, since both ETFs are essentially market-cap weighted, their top holdings lists are very similar, albeit with some reordering (e.g., due to sampling to market-weight major sectors).

So why did iShares, which already had the MSCI ETF, come out with the TOPIX? It felt that the shorter stock list was long enough to give broad market representation, but short enough to increase liquidity and keep expenses down (which it does), while still representing about 70% of the market value of the Japanese stock market. In these respects, investing in the TOPIX ITF is a decision comparable to investing in our S&P 500 index, rather than a broader measure like the Wilshire 5000.

If you're interested in buying individual stocks, but want essentially to index the Japanese market, check out the ETF's full list of holdings, available on the Web. Since the ITF is an unmanaged index fund, its top holdings change very slowly, due to market action, but iShares updates the list each month anyway (try getting that at an actively managed fund).

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