(Corrects ticker and fund performance for Matthews Asia Growth fund in paragraph 8.)
By David Randall
NEW YORK Jan 10 (Reuters) - Institutional investors have been increasing their holdings in Japan's surging stock market, yet investors may want to keep a narrow focus when adding exposure to Japan.
That's because the Nikkei index's 25 percent jump since mid-October is largely the result of new Prime Minister Shinzo Abe's intense pressure on the Bank of Japan to double its inflation target to 2 percent. The move, aimed at breaking Japan's long cycle of deflation, would weaken the value of the yen and could help make Japanese exports more competitive overseas.
Markets have begun pricing in the policy, similar to the U.S. Federal Reserve's rounds of quantitative easing. That has sent the dollar up more than 12 percent against the yen since November, hitting a 2-1/2-year high. A falling yen makes investing in Japan trickier for dollar-based U.S. investors. Even as stock prices go up, a falling yen eats into returns.
"It's a Catch-22 over there: the market only does well when the yen is weakening, and... that's not great because it hurts the currency translation," said Alec Young, a global equity strategist at S&P Capital IQ.
What's more, Japan has yet to tackle the structural problems of an aging population and massive debt that have sidelined the Japanese stock market, and economy, for nearly a generation, fund managers and analysts say. That will likely put a limit on any long-term gains.
For those who do want to chase the market, a two-pronged strategy of targeted buying of exporters, such as automakers, that may see their earnings rise in real terms, while simultaneously shorting the yen could provide a way around Japan's Catch-22, analysts say.
STOCK FOCUS, WITH HEDGES
The difficulty of simply investing in a Japanese-focused stock mutual fund is reflected in their returns. The top-performing, dollar-based Japan funds returned between 10 and 12 percent last year - underperforming the benchmark S&P index return of 13.4 percent - even though the Nikkei itself gained approximately 25 percent, according to Lipper data.
Investors should look instead for funds that take a broader bet on Asia and have currency hedges in place. One option: the $437 million Matthews Asia Growth fund, which charges $1.19 per $100 invested and whose annualized returns of 4.2 percent over the last five years put it 6.6 percentage points ahead of its category average. It returned 17.4 percent over the last year.
Fund manager Taizo Ishida has recently increased his stake in automakers like Honda Motor Co and Toyota Motor Corp . These companies will likely see their earnings rise, even after accounting for the depreciating yen, as a result of the monetary policy changes and increasing exports to countries like India and the Philippines, he said. Honda, which he added to the portfolio in the most recent quarter, has lagged its competitors, which he believes makes it the most likely to outperform over the next year. At the same time, he's been shorting the yen.
Honda, which is up nearly 6 percent so far in 2013, trades at a price to earnings ratio of 18 and offers a dividend yield of 2 percent.
Other investors are looking at exporters of consumer staples. While he remains skeptical about Japan's long-term outlook, Brett Gallagher, deputy CIO for Artio Global Investors, recently increased his allocation to Japanese stocks by 3 percentage points because of the expected monetary policy changes. He likes Unicharm Corp, a company that gets about 27 percent of its revenues from selling diapers and feminine care products to China and other Asian countries. The company is up 20 percent over the last year and trades at a P/E of 31.
"This is one of those companies that is in Japan but doesn't depend on Japan to be successful," he said.
Select banks may be another option for investors hoping to benefit from the monetary stimulus, said Andrew Sleeman, portfolio manager of Franklin Templeton's $38 million Mutual International Fund, which hedges for currency risk.
One of his largest positions is in Japanese bank Aozora Bank Ltd, which fell 10 percent Jan. 7 after reports that private equity firm Cereberus planned to reduce its stake in the company. The company will likely benefit from rising real estate prices that come as a result of the falling yen, which could in turn generate new rounds of lending, he said.
Some investors who have been short the yen see no reason to change their strategy.
Brain Hess, a fixed income manager at Brandywine Global, has been shorting the yen for more than a year. "The only way forward we see is a very aggressive, Fed-style policy of quantitative easing," he said. He's also shying away from Japanese corporate and bonds because of their relatively low yields.
Investors who want to take a bet on the direction of the yen could also opt for the WisdomTree Japan Hedged Equity ETF , a $1.4 billion fund that costs 48 cents per $100 invested. The fund, whose returns are listed after the currency conversion, is up 19.3 percent over the last year. (Reporting By David Randall; Editing by David Gregorio)