The Briefing: Japan

Japan is a fascinating country. As well as having traditions, such as the martial arts, woven into the fabric of its history, it is also a driving force in modern technology. This mesmerising blend of old and new makes it an intriguing area for would-be investors.

Unfortunately, those brave enough to put their money into Japan have also found it to be fraught with danger. Despite flattering to deceive on many occasions over the past decade, it constantly falls short of expectations, says Martin Bamford, managing director of advisory firm Informed Choice.

"Investors tend to end up in Japan because it's such a large economy and seen as a key country in that part of the world," he says. "It's one of those places that perpetually seems to be in a good position, so people tip it to improve but then it disappoints again and again."

Is this the right sector for me?

Consider investing in this sector if...

• you think Japan is about to finally "turn the corner"
• you want focused exposure to the country
• you are looking to diversify your portfolio

It's clear that anyone who shunned Japan will have missed out on last year's bumper ride when the Nikkei 225 Index shot up 57% to 16291. However, they will have also avoided the subsequent fall to below 14000, a drop of more than 10%. An analysis of the past 25 years shows this situation isn't unique. While the index peaked at nearly 39000 at the end of 1989, it has since experienced numerous false dawns. At the time of writing, it stands at just over 15000. Its next move, quite frankly, is anyone's guess.

"Most people go into Japan at the wrong time," points out Andrew Merricks, head of investments at Skerritt Consultants. "Now you're seeing a lot of people moving out of Japan, that may be a good sign to invest because no one ever seems to get it right."

However, sentiment towards Japan has improved markedly in recent years, according to Patrick Connolly, a certified financial planner at Chase de Vere. He points out that at the start of the year many commentators were tipping Japanese equities to be among the top performers in 2014.

"Prime Minister Shinzo Abe has ushered in a programme of economic stimulus that has even attracted its own name, 'Abenomics'," he explains. "He has pressured the central bank to ease monetary policy and doubled Japan’s inflation target to 2% in a bid to end the regular periods of deflation.”

Such initiatives devalued the Japanese currency, which has been good news for the country's exporters, whose products are more competitive, but bad for overseas investors who haven't been able to fully benefit from market rises after currency fluctuations are taken into account.

Although the reforms have had an impact and provided tangible signs of constructive change in Japan, Connolly points out there's no guarantee they will prove successful and suggests those committing new money to the region are taking a pretty big leap of faith.

"We have recently seen disappointing numbers on exports, trade and economic growth," he explains. "As a result, markets are becoming more sceptical about the future outlook for Japan."

Plenty of choice

However, this must be counterbalanced by the argument that it makes sense to have some exposure to what is one of the world's largest economies. There's also the risk that people will miss out should Japan finally turn the corner.

If you want to invest, then there's plenty of choice with more than 80 funds in the Investment Management Association (IMA) Japan sector and 10 in IMA Japanese Smaller Companies. However, you'll need to choose carefully as while the best funds in each sector have hit double-digit returns over the past year, the worst have lost money.

Markets are becoming more sceptical about the future outlook for Japan"Patrick Connolly

An alternative is to consider sectors that are not so closely tied to the prospects for Japan, such as IMA Asia Pacific including Japan.

The Japanese content of funds in this area must account for less than 80% of its assets - that's enough for you to access potential upside but with the risk diluted by exposure to other countries.

Over the past 10 years, this would have been the better option for as funds in this sector returned, on average, 131.85%, according to Morningstar figures to 4 June 2014. This is considerably more than the 45.3% recorded by IMA Japanese Smaller Companies or the 39% average achieved by IMA Japan.

Whether or not to put money into this area is certainly a tough call from an investor's standpoint, concedes Connolly, but even those who press ahead would be wise to limit the exposure to 5% of their overall investment portfolio.

"A risk is that those investors who sit on the sidelines may regret not jumping on to the new Japan story," he says. "Of course, another risk is that those who jump in might again end up battered and bruised and wondering if they will ever learn their lessons over investing in Japan."

This article is for information and discussion purposes only and does not form a recommendation to invest or otherwise. The value of an investment may fall. The investments referred to in this article may not be suitable for all investors, and if in doubt, an investor should seek advice from a qualified investment adviser.