Japanese companies have performed well this year, thanks largely to extreme monetary stimulus from the Bank of Japan. Increasing GDP growth and a weakening yen have seen sentiment towards the region turn increasingly positive and strong returns have followed.
Although the Topix rallied over the first part of 2013, it has moved sideways since, at a time when the yen was strengthening against the dollar.
Nevertheless, FE data shows the index has returned more since January than it has in any calendar year since 2005.
Performance of index year to date
Source: FE Analytics
Heslop, who manages the five crown-rated Old Mutual Japanese Equity fund, says that although the first two arrows of Abenomics have had the desired impact, he is more wary of the longevity of the rally.
"The sentiment surrounding Japan is the highest it has been for a very long time," Heslop said.
"We have had the first two arrows, but the market knows that the Bank of Japan is not going to turn the taps off, which is very different to elsewhere in the developed world as a normalisation in monetary policy is around the corner."
"Investors should expect the same amount of liquidity next year in Japan. However, it isn’t really about that any more as people know it is coming."
"The next question is how and when the third arrow will be fired and will it be sufficient to justify the current optimism?"
After decades of crippling deflation, prime minister Abe’s plan to reflate the economy caused many experts to tip Japan as the surprise package of 2013.
His first two "arrows" of monetary policy and fiscal stimulus, which revolved around quantitative easing from the Bank of Japan and increased government spending, helped certain areas of the equity market.
For example, Japanese funds with a high exposure to the country’s exporters benefited tremendously from the weakened currency.
The likes of Neptune Japan Opportunities, Legg Mason Japan Equity and Invesco Perpetual Japan – all of which have a bias to either smaller companies or more economically sensitive stocks – have returned in excess of 40 per cent over 12 months.
Performance of funds vs sector over 1yr
Source: FE Analytics
However, Heslop and an increasing number of industry experts are wary of the fact that more is needed for Japanese equities to continue their strong run.
FE Alpha Manager David Coombs recently told FE Trustnet that he is wary of Japan’s growth rate next year because there has been no real evidence of the third arrow of reforms being fired.
The third arrow of structural reform has the objective of opening up to international trade and boosting external investment into Japan. However, although Heslop is by no means bearish on Japan, he says this third stage will be the most difficult of the three to implement.
"It’s not just about bringing in inflation, what investors need now is for the policy-makers to have the political will and bravery to take a vested interest in the economy," Heslop explained.
"It’s all about the restructuring of the economy. For instance, they have massive tariffs on rice to protect domestic producers. The problem is, these producers tend to be very small farms which are not automated," he added.
The manager says that large parts of the Japanese economy are backed up by political will. For example, agriculture dominates the LDP (the ruling party in Japan), so Abe will need a huge amount of political bravery to push through the reforms.
"From a monetary standpoint, we know that isn’t going to change. However, what needs to happen is actually harder to implement," Heslop said.
"If the changes come through, it will be good news for equity markets. If Abe is not able to provide the structural reforms, however, it won’t," he added.
Heslop has managed the £29m Old Mutual Japanese Equity fund, along with Amadeo Alentorn and Mike Servent, since December 2011.
According to FE Analytics, the fund is a top-quartile performer in the IMA Japan sector over this time with returns of 35.38 per cent and has beaten is benchmark – the MSCI Japan index – which has returned 27.62 per cent.
Performance of fund vs sector and index since Dec 2011
Source: FE Analytics
The Old Mutual Japanese Equity fund also boasts top-quartile returns over one year.
Heslop, Alentorn and Servent take a different approach to investing compared with many of their peers and use their strategy across a range of funds, such as Old Mutual Asia Pacific, Old Mutual North American Equity and Old Mutual Global Equity.
Instead of having either a value or growth bias in their funds, the managers attempt to create a more blended portfolio of stocks that can perform in any given market environment.
Old Mutual Japanese Equity has an ongoing charges figure (OCF) of 1.74 per cent and requires a minimum investment of £1,000.
Next week, Heslop will tell FE Trustnet more about his team’s process and why investors are limiting their options by sticking to a single investment strategy.
