Think Your Funds Need Diversity? Try Japan

If you’re worried about the high-flying U.S. stock market, you might want to shift some money into international mutual funds. Believe it or not, you should even consider funds with hefty stakes in Japan.

At first glance, that might not sound too enticing. After all, who would want to pull money out of the robust American stock market and redeploy it in Japan, where investment profits in recent years have been as scarce as elbow room on the Tokyo subway?

But you can make a good argument for doing so from a contrarian or bargain-hunting standpoint. You can make an even stronger case for reasons relating to international diversification--the notion of spreading your assets among stock markets in different nations that don’t all rise and fall together.

Simply put, Japan is a key market to which any well-balanced portfolio should have exposure. Despite tough times so far in the 1990s, Japan still has the world’s second-largest economy and stock market. Also, the nation remains a global leader in key industries such as auto making, electronics and finance, and it’s poised to be a major player in the economic development of China.

Most critical, Japan is a key link in any strategy designed to reap the benefits of global diversification. Several studies have attempted to answer the question of whether such diversification still pays, and they have reached conflicting conclusions. But they do agree that Japan’s market is one of the best diversifiers, for the simple reason that stock prices there don’t move in sync with what’s happening in the U.S.

For example, a study released earlier this month by Morningstar Inc. of Chicago determined that foreign mutual funds generally didn’t deliver very good diversification over the last 20 years, partly because portfolio managers have been cutting back on their Japanese weightings.

On average, foreign funds hold just 16% of their assets in Japanese stocks, says Tricia Rothschild, international editor for Morningstar. That compares with a 26% Japanese weighting in Morgan Stanley Capital International’s World Free Index, which tracks all foreign markets. If you include U.S. stocks in the mix, Japan weighs in at 15% of the world total.

A May study by the No-Load Fund Analyst newsletter in San Francisco determined that foreign diversification generally doesn’t provide much protection, especially at times when the U.S. market is falling fast.

But of the half-dozen major markets that were examined over a 27-year period, the newsletter found that Japan, along with Italy, offered the best diversification, while stocks in Canada and Britain provided the least. The two other countries, France and Germany, scored in the middle for risk reduction.

Unlike the two other studies, a September 1996 study by Morgan Stanley Capital International in New York affirmed that global diversification still makes sense as a risk-reduction tool. In fact, this study, which focused on the U.S., Japan and Britain, found that the three markets were even less synchronized with or “correlated” to one another from 1993 through 1996 than they had been over the previous 22 years.

But like the other two studies, Morgan Stanley’s research found high diversification benefits for Americans owning stakes in the Japanese market. Stock-price movements between the U.S. and Japan largely were unrelated over the two periods, suggesting that shareholders could help smooth out their overall returns by investing in both markets.

“Many investors believe that the world’s developed economies have become more integrated, and they question whether diversifying still reduces risk in an international portfolio,” reads the Morgan Stanley study. “The results show that . . . international diversification is still an effective way for investors to lower volatility [and that] developed markets are not more closely correlated now than they were in the past.”

By now, you’re probably wondering about the value of Japanese diversification if stocks in that market are always treading water or falling. The answer is that the country’s economic malaise won’t last forever and that after seven years of a bear market, things might look up sooner rather than later. It seems like a distant memory, but Japanese stocks performed spectacularly well in the 1980s, and a bull market could resume at any time.

In fact, mutual funds that focus on Japanese stocks gained 19% during the current quarter through June 12, reports Lipper Analytical Services of Summit, N.J.

Although you can choose from nearly 30 mutual funds that specifically target Japanese stocks, such a concentrated approach isn’t necessary. All you really need to do is make sure your current international fund maintains a sufficient exposure to Japanese stocks.

What’s sufficient? One good measure would be the 26% stake that Japanese stocks represent in Morgan Stanley’s foreign-market index--not the much lower percentages that seem to be in vogue these days.

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Russ Wiles is a mutual fund columnist for The Times. He can be reached at [email protected]

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Sizing Up Japan

Although it has performed poorly during the 1990s, Japan’s stock market is still the second-largest in the world and one to which investors should maintain some exposure, a recent study says.

Value of stock market as a percentage of world total:

U.S.: 42.2%

Japan: 15.1

Britain: 9.3

Germany: 4.2

France: 3.2

Switzerland: 3.1

Other developed mkts.: 15.1

Emerging markets: 7.8

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Source: Morgan Stanley Capital International