Japan’s economy has been hit very hard by the global recession. With interest rates already at low levels, unemployment rising and continued political instability, the country’s short-term prospects look poor.
The equity market performed poorly in 2008, with the Topix down 41% in yen terms, its worst ever post-war year.
Exporters especially are struggling, partly due to the appreciation in the yen, up 42% against sterling last year. This currency movement cushioned the market fall for sterling-based investors, making Japan one of the better places to be invested, with a positive sterling-based return on the Topix of 1% for the year.
Against this backdrop, Japanese investment trusts performed poorly last year, with every fund lagging its respective benchmark and the equivalent open-ended peer group. Most trusts were geared into the falling market and many were overweight cyclical stocks and particularly exposed to a downturn.
There were also specific issues, such as Morant Wright Japan Income, whose structure meant it suffered from the strengthening yen, and Prospect Japan, whose high J-Reit exposure proved a drag on performance. Ironically, the best performer, Perpetual Japanese, was wound up in December.
Discounts on Japanese investment trusts have largely reflected investor interest in Japanese equities, and when the market has performed badly, discounts widened substantially.
Of course this is true for all investment trusts to some extent, but in the case of the Japanese sector, the effect is magnified not least because few funds have active discount control policies.
Conversely, when sentiment does improve, the Japanese sector has been shown to rebound sharply. When the market turned in 2003, discounts narrowed quickly from about 20% and the sector traded on a premium in the 2005/06 bull market.
Discounts are currently at the widest levels for a decade, with the average discount for larger cap funds about 20% and 22% for smaller cap funds. This is despite the fact that supply has been considerably reduced in the sector over the past three years with the delisting of Martin Currie Japan, Invesco Japan Discovery and Perpetual Japanese.
Despite their poor recent performance, we believe investment trusts are an attractive way to play any market recovery, given that average discount levels are wider than 20% and we would expect discounts to tighten when conditions pick-up. Furthermore, investment trusts have tended to be higher beta plays and some have the potential to deploy gearing. We believe that the sector is well placed to outperform when the market turns.
We are currently recommending Baillie Gifford Japan, managed by Sarah Whitley, and Schroder Japan Growth, managed by Andrew Rose. Baillie Gifford Japan has a good long-term record and tends to outperform in rising markets. Schroder Japan Growth benefits from an experienced manager and is focused on larger cap companies.
As a recovery play, we would highlight Melchior Japan, whose performance has picked up following a review of the company’s investment strategy.