Why even the cautious are piling into Japanese stocks

Time for a small confession. I am absolutely no Japan bull. But even I've been hedging my bets over the last year with a reasonable-sized investment in Japanese small caps, via an exchange-traded fund (ETF) from iShares, which tracks a small-cap variant of the broad market MSCI index.

That admission shouldn't be taken as evidence that I am bullish on Japan. Far from it. I've already started taking profits on this position as I can't help but think that the 50%-plus rally in Japanese small caps has maybe got a little ahead of itself. I'd also echo the caution of one my favourite quantitative analysts Andrew Lapthorne at Socit Gnrale.

He observes that, although in the last week the Topix, a rival to the main Nikkei index, has risen by "a decent 3% in yen terms... in sterling and dollar terms, the rise in pricing is a more muted 0.8% and 0.9% respectively. So investors certainly need to keep an eye on their true returns, rather than seeing a strong headline figure for the rise in local market pricing and paying up accordingly without pricing in highly volatile changes in the FX [currency] component."

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But even I'd admit that the optimists still have one very strong card to play: momentum. On whichever measure you choose to look at, Japanese shares do look to be flavour of the month'. Fund inflows are massively favouring Japan over, say, China, and most measures of growth in earnings per share (EPS) show very strong profits growth in Japan over the next few years.

This positive momentum has fed through into fascinating sector shifts small caps have done very well, but perhaps the biggest Japanese sector gainers have been consumer goods or services sectors. This, in part, cements the consensus view that by creating a fear of inflation, cash-laden Japanese will decide to go out and spend. So one might conclude that Japanese equities will continue their upward progress for as long as foreigners show an interest.

So what funds should investors look at if they want to access this strong momentum-driven narrative? I always have a preference for the ample liquidity and relatively low cost of investment trusts over unit trusts. Top dogs in terms of alpha' generation in investment-trust land has to be the team over at Baillie Gifford.

Baillie Gifford Japan (LSE: BGFD), its main large-cap fund, has a total expense ratio (TER) of 1.21%. BG Shin Nippon (LSE: BGS), its smaller cap alternative, has a TER of 1.51%. Both have produced some sparkling numbers over the last year, moving from big discounts (where the share price trades below the value of the shares in the underlying fund) to premium territory (when it rises above).

But the strong momentum behind Japanese equities may now be favouring alternative fund managers. Paul Locke at CFE Research recently suggested to institutional investors that the underlying asset base of the JP Morgan Japanese Investment Trust (LSE: JFJ) "has done particularly well in recent days, benefiting from its holdings in, among others, Sumitomo Realty & Development... With the central bank now advertising that it will purchase real-estate investment trusts [Reits], this stock has risen by some 24% in the last two days alone (19.3% in sterling terms)."

Not all investors are entirely comfortable dealing with stockmarket-listed funds, of course. The good news for them is that over in unit-trust land there's much, much more choice although fund costs are higher, usually by between 20 and 50 basis points a year.

Top performers over the last five years have included M&G Japan Smaller Companies and Legg Mason Japan Equity, but if we were to use fund ratings as an alternative guide, a more familiar bunch of names would emerge. Solid long-term performers include GLG Japan Core Alpha fund and Jupiter Japan Income, with a handy yield of 2.2% a year.

There's also the Schroder Tokyo fund, whose manager also runs an investment trust called Schroder Japan Growth (LSE: SJG), and Invesco Perpetual Japan Fund, run by the highly regarded Paul Chesson.

Smaller, more specialist managers with excellent reputations include CF Morant Wright Japan, JO Hambro's Japan fund and Polar Capital Japan fund.

Investors looking to play these broad Japanese trends should also consider passive alternatives ie, funds that track a major index, such as the Nikkei or the Topix. These index-tracking mutual funds and ETFs obviously don't have any active management of risk, but the costs are also much lower, with most ETFs charging a full 1% less per year than their actively managed unit-trust peers.

In the ETF space there are two main options. You can buy a fund that physically tracks an index, such as the HSBC MSCI Japan (LSE: HMJP) fund, which charges just 0.5% a year. Or you can opt for a synthetic' tracking fund, which use swaps-based structures to track an index closely and keep tracking error the gap between the fund return and the index return to a minimum.

In the latter category, you'll find funds such as the Amundi MSCI Japan fund (LSE: CJ1) and Lyxor TOPIX Japan fund (LSE: JPNL), which both charge just 0.45% in total fees. Investors also need to be aware that there are different indices on offer. The MSCI index is the very broadest, whereas the Nikkei is much more large-cap focused.

Another alternative idea is to focus on a particular part of the Japanese equity markets. Among the most popular recent choice are locally traded small caps. These are tracked by actively managed funds, such as the aforementioned Baillie Gifford Shin Nippon and M&G Japan Smaller Companies, or through the iShares MSCI Japan SmallCap ETF (LSE: ISJP) I mentioned in the introduction.

These smaller companies will be much more volatile than their larger-cap peers and arguably they've already seen the best of the upturn in sentiment, yet it's also true that smaller Japanese companies boast some of the best balance sheets and strongest growth prospects in the market especially if the local consumers do eventually shows signs of life.

For more adventurous investors, there is one last alternative, in which I have a small position myself. The Japan Residential Investment Company (LSE: JRIC) is a specialist closed-end fund that invests in Japanese residential flats in key urban areas: typical yuppy flats in prime positions.

The fund aims to generate an income of at least 5% a year, plus some prospect of capital gains if apartment prices start to gain value (after decades of falling property prices). This income-based alternative, effectively a Japanese Reit, is still trading at a chunky discount to its book value and is an alternative play, alongside Jupiter Japan Income, for income-orientated investors.