Japan: It’s not too late to join the party

There's no doubt that the turnaround story of 2013 was Japan. After several years of disappointment, stocks soared as investors realised that the radical policies of new prime minister Shinzo Abe might finally bring an end to the country's two-decade economic malaise. The MSCI Japan index gained more than 50% in the course of the year, making it the world's best-performing major market.

After such a strong performance, is there room for more in 2014? Certainly the economic news looks encouraging. Deflation seems to be on the way out, with the core consumer price index rising by 1.3% year on year in January. Companies are under growing pressure to raise salaries, which should help to support consumption and boost growth; the steady decline in wages over the past 15 years has arguably been one of the core causes of Japan's prolonged slump. And the government seems committed to structural reforms to shake up the most restrictive and uncompetitive parts of the economy.

Meanwhile, despite recent gains, valuations continue to be relatively attractive. The MSCI Japan trades on a price/earnings ratio of 15 and price/book-value of 1.25, while the MSCI World is on a p/e of 18 and a p/b of 2.1. So while the next stage of the Japanese recovery is unlikely to be quite as dramatic as the first year, we think the bull market still has a long way to run.

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Our favourite Japanese funds

There are plenty of Japan funds to choose from, but we've long been keen on two investments trusts from Baillie Gifford. The Baillie Gifford Japan Trust (LSE: BGFD), managed by Sarah Whitley, is essentially a flexi-cap' fund, meaning that it can investin companies of all sizes, although ithas traditionally had a bias towards medium-sized and small companies. Its ongoing charges an indicator that replaced the total expense ratio and is calculated as total operating costs divided by average net asset value were 1.13% in 2013.

Baillie Gifford Shin Nippon (LSE: BGS), managed by John MacDougall, is explicitly a smaller companies fund (Merryn Somerset Webb, MoneyWeek's editor-in-chief, is adirector of Shin Nippon). Ongoing charges were 1.53%.

Both have performed extremely well since the Japanese recovery begun, with Shin Nippon unsurprisingly doing best due to its greater small-cap focus. As a result of this, both now trade on a premium to net asset value, of 2.24% and 6.79% respectively as of the first week of March. Generally, you should avoid buying investment trusts at a premium to NAV, but in this case, the managers' records suggest it may be worth considering.

Alternatively, the Atlantis Japan Growth Fund (LSE: AJG), managed by Ed Merner and Taeko Setaishi, is a solid choice in our opinion. It trades on a discount to NAV of 3.75% and has ongoing charges of 2.16%.

Turning to unit trusts and OEICs, the Baillie Gifford managers each run an open-ended fund with a similar mandate to their investment trusts: the Japan Fund and the Japanese Smaller Companies Fund. The new clean' share classes for these (ie, those that don't pay trail commission) have ongoing charges of 0.66% and 0.61% respectively. There is significant overlap between the holdings of the investment trusts and the open-ended funds, but the historic performance of the investments trusts has been substantially better and we'd stick with those unless you have a strong reason to choose open-end funds.

If you do, a more interesting choice might be the Legg Mason Japan Equity Fund, managed by Hideo Shiozumi. This is another small-cap fund with a strong long-term record, although even more volatile than the funds we've already mentioned. Ongoing charges last year were 1.94%.

For those who would rather invest in a low-cost tracker fund, there are number of choices. The Vanguard FTSE Japan ETF (LSE: VDJP) has ongoing charges of 0.19%, making it the cheapest at present for longer-term investments. The iShares MSCI Japan ETF (LSE: IJPN) has significantly higher costs (0.59%), but is more liquid and has a tighter bid/offer spread, so could be a better choice for short-term trading. iShares also offers large cap (LSE: CJPL) and small cap (LSE: ISJP) products, with ongoing charges of 0.48% and 0.59% respectively.

To hedge or not to hedge?

The spectacular gains in Japanese stocks last year were reduced for UK-based investors by the significant decline in the yen versus sterling. One of the biggest questions for investors is whether this is likely to be repeated. If it is, it might make sense to invest in a fund that hedges into sterling, which would mean that its returns should not be affected by how the yen performs.Our view is that the very large drop in the yen that we saw in late 2012 and early 2013 is unlikely to be repeated. The decline came at a time when the currency was extremely overvalued and reflected a sudden awareness that Japanese policymakers were finally serious about taking whatever action was needed to end deflation. This reality should now be fully priced into the market.However, if you would prefer to hedge, there are a number of funds that enable you to do so. We would favour looking for one that has a hedged share class that is consistly hedged into sterling, rather than one where the manager has the discretion to hedge when they want; there's little reason to expect an equity fund manager to be good at forecasting currency movements, so delegating the decision to them makes no sense. Many popular Japan funds offer hedged share classes, including the Legg Mason Japan Equity Fund. Investors in passive funds have a handful of choices including the iShares MSCI Japan GBP Hedged ETF (LSE: IJPH), which has ongoing charges of 0.64%.