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Money Follows Returns to the Land of the Rising Funds

While some money managers urge caution, money is pouring into Japan.

That sucking noise you're hearing is the sound of investments being siphoned out of Europe by the surge in Japanese stocks.

But will that soon be followed by the sound of a bubble bursting?

The Asian recovery is producing some Internet-like returns for mutual funds. Through Thursday, the average Japanese fund was up 58% year-to-date, and returns of several Japanese small-company funds are in triple digits.

And where returns are spiraling upward, investors' money is never far behind. In June and July alone, $734 million flowed into the sector. Assets in Japan funds had ballooned to $4.3 billion by the end of July, up from just $1.7 billion at the beginning of the year, according to

Financial Research Corp.

in Boston.

The pros' money is heading east as well. Last year at this time, the average international fund had 65.8% of its assets in Europe, according to


. That's now fallen to 60.4%. Meanwhile, international funds' weighting in Japan was 16% as of June 30, up from 10.7% a year earlier.

The shift is ironic, given that last year at this time, portfolio managers wouldn't touch Japan with a 10-foot pole. Instead, international meant all of the world outside the U.S. -- as long as it was inside Europe.

But the average European fund is stuck in neutral this year with an average return of 0.3%. That has led many once-skeptical portfolio managers to take a second look at Japan despite its recent record of disappointment. The five Japan funds with a 10-year record tracked by


have an average annualized return of negative 1.3% over that period.

Bears in the region say skepticism is still warranted. They worry that the recovery has been based largely on the assumption that things couldn't get any worse. Yes, there's been bank reform in Japan, and the country's institutions seem to be getting serious about dealing with debt. The yen has stabilized somewhat and has risen against the dollar despite pullbacks this week. Big companies such as



finally seem to have accepted that giving someone a job for life isn't exactly a prime motivator for the employee or the company's stock. But that doesn't necessarily add up to a sustained rally, skeptics say.

"It's almost reminiscent of what went on in Europe last year. Everyone was so positive on Europe, and there was so much hoopla over the euro, that I think it was a little overbought. That could be the case with Japan now," says Albert Sebastian, co-manager of the

(USIFX) - Get Free Report

USAA International fund.

Sebastian has only 13% of his fund's assets in Japan and is overweighted in Europe. From his point of view, the currency fluctuations that took gains away from investors in Europe this year have balanced themselves out and will provide future opportunities there.

"Long term, Japan has got some problems," Sebastian says. The


has seen a tremendous trade up in valuation, but it's still unclear whether Japanese corporations are serious about restructuring to cut costs, he says. The megamerger of

Industrial Bank of Japan


Dai-Ichi Kangyo Bank


Fuji Bank

will create the world's largest financial group, but the country is still straddled by mountains of debt. And its aging demographics will put an incredible strain on its social-security system by 2025.

Despite those fears, some international managers are taking a second look at Japan because, with Europe slumping, there aren't that many alternatives. The huge gains in U.S. and European markets in recent years have also been causing some nervousness for investors afraid of falling.

"In the end, there was only one economy left -- the second-biggest economy in the world -- that hadn't done anything, and that was Japan," says Thomas Mengel, manager of the $1.2 billion


United International Growth fund.

Mengel started shifting toward Japan early this year and now has more than 20% of his assets there, compared with 65% in Europe.

Drew Collins, manager of the $300 million


Federated International Equity fund, also started shifting assets to Japan earlier this year.

"You're coming out of what has been a 10-year bear market in Japanese equities, so you're staring from very low valuations," Collins says. "So even though this market is up substantially, we think it has further to go."

At the end of June, his fund had a 27% weighting in Japan, slightly more than the 26% Japan weighting of the

Morgan Stanley Capital International EAFE

index. "We're a bit higher than that now and well overweight the market," Collins says.

Still, even newly converted believers sound some cautionary notes about the longevity of Japan's rally.

"Is there life left?" United's Mengel asks. "There is life left if the Japanese companies will become more and more serious about restructuring. If that comes through, then the market has more to go. Sure."

But one investment adviser worries about investors getting trapped chasing after past returns.

"Looking at the international sectors that have already risen, I think the gains have already been taken," says Lou Stanasolovich, president of

Legend Financial Advisors

in Pittsburgh. "I think that it's probably a better idea to invest in other undervalued securities or asset classes or styles that have not taken off dramatically yet."

He says those other sectors might include small value stocks, real estate and mid-cap stocks closer to home.