Funds in two of the most ignored sectors in the Investment Association universe have the lowest correlations to UK portfolios, which could offer a hunting ground for investors worried by the high valuations on offer in leading equity markets.
Investors are frequently told to seek uncorrelated sources of returns for their portfolios, as having assets that move in lock-step with each other is rarely a prudent strategy. While things may look good when all the holdings are moving up at the same time, having highly correlated investments means they will tend to lose money together as well.
However, correlations have largely grown in the years since the global financial crisis after factors such as investors’ flight to safety and unprecedented monetary easing by the world’s central banks drove them into similar assets.
The table below shows the five-year correlations of the IA UK All Companies and IA UK Equity Income sectors with other popular equity peer groups and the four multi-asset sectors. A correlation of 0.70 or above is considered to be high.
Source: FE Analytics
As can be seen, those invested in UK funds have a high correlation with other equity funds, which is to be expected although the extent to which this is true may surprise some.
What investors may not have expected is the high correlations between the average UK and multi-asset funds, given that diversification is often sold as a key attribute of multi-asset portfolios.
However, FE Analytics shows the equity sectors with the lowest correlations to the FTSE All Share are IA Japan and IA Japanese Smaller Companies – which are frequently overlooked by retail investors.
IA Japan has a 0.37 correlation with both the IA UK All Companies and IA UK Equity Income sectors; correlations for the average IA Japanese Smaller Companies fund stand at just 0.21 for both UK sectors.
Many UK investors avoid Japan, especially the smaller companies sector which is the smallest Investment Association peer group with assets under management of just £400m.
Last month, JP Morgan Asset Management global market strategist Kerry Craig described Japan as a “Marmite” market, saying investors are either very confident on its prospects or will not go near it.
The Nikkei 225 has had a strong start to the year, posting a total return in sterling terms of 14.77 per cent. While it has lagged Russia and China, Japan has outpaced the gains seen in the UK, the US, Europe, global emerging markets and global equities.
Performance of indices over 2015
Source: FE Analytics
Despite this – and its strong performance in recent years after the implementation of the ambitious ‘Abenomics’ stimulus programme – investors continue to shy away. But Craig highlights a number of features that could prove attractive, given the fact that many other developed equity markets are trading at record highs.
“There have been too many false dawns in Japan for any investor to consider its equity market to be a sure thing. Given the depth of the country’s structural problems, it’s admittedly too early to judge whether Abenomics is working,” the strategist said.
“But the Japanese equity market has had an excellent start to the year and there are several reasons to think that it will be supported in the medium term: attractive valuations, decent earnings momentum and continued structural support from official sources.”
“The idiosyncrasies of the Japanese market may also hold some attraction for global investors hungry for diversification. Over the last three years, the MSCI Japan Index has had the lowest correlation with global equities of any of the major developed markets.”
As mentioned above, the IA Japanese Smaller Companies peer group is the sector with the lowest correlation to UK funds. While this is a very niche area to be investing in, there is one fund from the sector rated highly by FE’s analysts.
Performance of fund vs sector and index over 5rs
Source: FE Analytics
Baillie Gifford Japanese Smaller Companies, which is headed up by FE Alpha Manager John MacDougall, appears on the FE Select 100 thanks to its long-term outperformance and thorough stock analysis.
“MacDougall likes to invest in companies run by the ‘new generation’ of Japanese managers. These are more globally orientated, adopt modern management techniques and tend to be found in internet-related sectors and the healthcare industry,” the FE Research team said.
“He also invests in exporters, although they do not make up the bulk of the portfolio. Investors should be aware that the nature of this fund means it is likely to experience large fluctuations in value.”
The fund’s five-year correlation to both UK sectors is the highest of its peers at around 0.25. However, it has returned 80.42 per cent over three years and 93.70 per cent over five, making it one of the peer group’s best performers.
Baillie Gifford Japanese Smaller Companies has a clean ongoing charges figure of 0.62 per cent.
Those looking to invest in the IA Japan sector, which is significantly larger with £13.9bn of assets, have two FE Select 100 funds to consider: Baillie Gifford Japanese and Neptune Japan Opportunities.
Performance of funds vs sector and index over 5rs
Source: FE Analytics
Sarah Whitley and Matthew Brett’s Baillie Gifford Japanese fund focuses on quality companies with sustainable growth potential and tends to avoid the market’s largest companies, which FE’s analysts believe will make its returns more consistent and less volatile than its peers’.
It has a five-year correlation of 0.37 with UK growth funds and 0.38 to equity income funds, while its 62.73 per cent return over this period places it in third place in its sector ranking.
The four FE Crown-rated fund is also rated ‘AA’ by Square Mile Investment Consulting & Research, whose analysts said: “The longer-term time horizons used by Baillie Gifford are different to those of many Japanese equity investors and the quality of the team's skills, combined with its experience, provide it with a fine platform from which to identify attractively priced Japanese securities.”
“All of these factors make this fund a standout proposition from its peers and one that should definitely be considered by investors considering a long-term allocation to Japanese equities.”
FE Alpha Manager Chris Taylor’s Neptune Japan Opportunities is also first quartile over three and five years, with respective gains of 87.02 per cent and 41.60 per cent. However, its five-year correlation of around 0.50 to UK funds is the highest of its sector.
The FE Research team said: “The fund is entirely shaped around the manager’s macro-economic view of Japan, which is that the country must depreciate its currency to increase the value of overseas earnings in order to raise enough corporation tax not to go bust.”
“He buys companies which earn their money overseas in order to take advantage of this process and also because they will be the best performing companies if the country fails to weaken its currency and goes bankrupt. The fund is therefore highly sensitive to the strength of the Japanese currency and to success in the current economic strategy.”
Baillie Gifford Japanese has a 0.68 per cent clean OCF while Neptune Japan Opportunities charges 0.82 per cent.
Of course, not every investor will want to allocate to a Japanese fund to add some diversification to their portfolio. In a series of future articles, FE Trustnet will look at the funds with the lowest correlation to some of the most popular funds with investors.
