Flows Potential: Fund Managers Remain Under Weight Japan

The recent bout of aggressive monetary policy easing by the Bank of Japan (BOJ), combined with the direct purchases of equities by the Japanese Government Pension Investment Fund (GPIF), has brought on a new period of positive sentiment toward Japanese equities. In previous blog posts, we have outlined the direct buying by the BOJ and GPIF and how that should translate to greater inflows into Japanese equities. We have maintained that equity valuations remain supportive for the Japanese markets and want to discuss another set of market participants who may be looking to add exposure to Japan: mutual fund managers in the U.S. operating global portfolios who appear to us to be still under-weight Japan in their portfolios. Some have described Japan as a crowded trade, in that many investors were already “all-in” in 2013 with strong inflows of $150 billion in terms of foreign investor purchases. However, our review of the U.S. mutual fund data—based on funds that offer information about country allocations—shows that money managers are still under-weight Japan compared to more passive foreign indexes that allocate based on market capitalizations. Below we discuss some key takeaways that summarize flow data in both the open-ended and exchange-traded fund (ETF) space—while maintaining a focus on Japanese equity allocations.   Japan Equity Allocations and AUM across Broad-Based Open-Ended and ETF Funds Domiciled in the U.S.   • Total Assets under Management in Dedicated Japanese Equities grew 270%. Since December 2011, total assets in Japanese dedicated equity funds in the ETF and open-ended space grew from $8.35 billion to $30.95 billion in September 2014.   - Japan Dedicated ETFs Expanding AUM Market Share: In December 2011, Japan-focused ETFs had 3x the AUM of Japan-focused open-ended funds for total AUM of $8.35 billion. By September 2014, mutual fund assets doubled, but ETF assets quadrupled, so the ratio of Japan dedicated ETF AUM was 6.4x the Japan dedicated open-ended fund AUM. According to the data above, this is one illustration of how ETFs have become preferred access vehicles for country exposures.   • Broad Open-Ended Funds Appear Under-Weight Japanese Equities: When compared to the ETF Funds in the same Morningstar category, foreign large caps, active managers have allocated 13.77% to Japanese stocks, while passively managed ETF strategies have a 17.58% allocation to Japanese equities. This reflects 3.81% under-weight allocation to equities in Japan. If active managers were to close this under-weight position, it could lead to more inflows to Japanese equities. - Potential for Flows: If the managers we tracked removed their under-weight position, this would imply additional inflow of approximately $31 billion to Japanese equities. To put this in perspective, this is approximately one-third the total assets in the ETF foreign large-cap category within the U.S.   - Important Note: This context of potential flows is only from a subset of the broad market universe of funds where country allocation data is available. We identified $811 billion of fund assets where Japan country exposure is reported, but the total size of the foreign large blend category is approximately $1.1 trillion. If other funds that do not report Japan exposures show similar patterns of being under-weight Japanese equities, the amount of flows to Japan from just U.S. diversified mutual funds could thus be closer to $42 billion. Since the inception of "Abenomics," TOPIX returned 77.64% cumulatively.¹ Interestingly, the yen decreased significantly over this period, which neutralized some of the equity price rise and lowered the relative exposure in market cap benchmarks. In the ETF space, flows have gone toward currency-hedged ETFs over the last two years, which help neutralize this effect. Global investors may slowly be convinced to stow away their two-decade-long perception of poor Japanese equity market performance. Japanese Prime Minister Shinzo Abe’s team is showing a strong commitment to breaking the deflation cycle. After two lost decades of poor performance for Japanese equities, money managers may have to re-evaluate their habitual under-weighted Japan position on the back of a weakening yen, improving earnings outlook and still very reasonable market valuation multiples. Unless otherwise stated, data source is Morningstar, as of 10/31/14.         ¹Total returns between 11/30/12 and 10/31/14.