Will Japan's new financial dawn be as fleeting as the cherry blossoms?

As returns soar on Japanese funds, Simon Hildrey asks if investors can believe that this recovery will last
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"Japan go up? We've heard it all before," warns Ryan Hughes, an analyst at independent financial adviser (IFA) Chartwell Investment. He is not alone in his scepticism.

The country has long been considered a high-risk investment for most investors; there have been too many false economic dawns in the land of the rising sun.

"Every 18 months or so, we hear stories of a rally and that, this time, it's for real. But it has left us very cynical indeed about investing there," says Mr Hughes. Chartwell won't put money lying in clients' discretionary portfolios directly into Japan. Instead, it chooses to invest their cash in a global growth investment trust run by Foreign & Colonial; this has 10 per cent of savers' money in Japanese companies.

The reticence of Mr Hughes is matched by that of Patrick Connolly, the research and investment manager at IFA John Scott & Partners (JS&P): "We do use Japan in client portfolios but only to a limited degree. Because of the high-risk nature of the region, the vast majority of our clients will hold significantly less than 5 per cent of their portfolio in the country."

Such caution is linked to Japan's miserable recent economic history. Since the collapse of the property asset bubble in the late 1980s, political attempts to revive Japan's stuttering economy and clean up its debt-ridden banking sector have failed.

Yet new economic data over the past few months has led to fresh economic arguments suggesting that the current recovery is critically different from those before.

Only last week, business confidence edged up to its highest level for seven years, with Japanese companies expecting to achieve average profit margins of 4.25 per cent - their highest level since statistics were first compiled in 1982.

Indeed, for British investors who were prepared to take a punt on Japan's recovery last year, the rewards have been considerable.

The average Japan fund has grown by some 70 per cent over the past year, according to Standard & Poor's (S&P), the ratings agency. The best performer, the Framlington Japan income fund, has roared ahead by 128.18 per cent. If you had invested £1,000 in this fund on 7 April last year, it would be worth £2,281.80 now. Legg Mason's Japan Equity fund scored the second-biggest rise, turning a £1,000 investment into £2,111.04

Although Japan's economy has long carried a health warning, there does seem to be a lot of data now to persuade investors prepared to take a long-term punt.

The upbeat economic forecasts are in part down to rapid growth in China sucking in Japanese goods. Overall, Japanese exports rose by more than 10 per cent year-on-year in February and have increased in five out of the past six months. Despite voracious demand from China, however, the US remains Japan's largest export market.

The Japanese economy is growing too: it was up by 1.6 per cent in the final three months of 2003. Such a recovery has fuelled a rise in the Japanese stock market. The Nikkei 225 increased by more than half (52.4 per cent) between 28 April 2003 and 1 April 2004, compared with a rise of 22.03 per cent in London's FTSE All Share index in the same period.

Some fund managers are optimistic that things really have changed for the better.

Hideo Shiozumi, the manager of the Legg Mason Japan fund, suggests that the recovery has been driven by corporate change - rather than government spending - and an upturn in consumer spending.

"Japanese companies have been taking matters into their own hands and getting back into shape," he says.

Also bearing fruit have been measures introduced by the government. Led by Prime Minister Junichiro Koizumi, it has cut the number of "bad performing" loans crippling the corporate sector by forcing companies to pay off what they owe before they sink beyond redemption into bad debt.

But Rob Burdett, a co-head of the Crédit Suisse multi-manager service, which invests in other funds, says more economic restructuring needs to be done to ensure a sustainable recovery. "We became more optimistic when the Bank of Japan started tackling the banking crisis."

His insistence on restructuring is echoed by David Mitchinson, the manager of the Framlington Japan fund. Only with such changes is long-term growth - and higher returns - then possible, he stresses. "Although banks are less inclined to prop up weaker companies, this practice still exists and thwarts the possibility of a sustainable and dynamic Japanese economy.

"And increased competition can only happen," he says, "when 'zombie' companies are allowed to go bust. Until then, any recovery will be linked to the US and is merely cyclical."

He also points out that the Japanese government can't stimulate the economy by cutting interest rates since they are already at 0 per cent.

However, if you are keen to spread the risk in your portfolio and believe Japan could be worth a long-term bet, take time out for research. Most of the 70 or so funds investing directly in Japan can be put into an individual savings account (ISA), and the Investment Management Association's www.investmentfunds.org.uk website is a good place to start looking for them. It lists the funds targeting Japan and the Far East.

If you don't like the idea of such high risk, S&P's www.funds-sp.com website lists 10 funds that invest in the Asia region as well as Japan.

Mr Connolly at JS&P prefers not to select single Japan funds for clients and says the IFA will combine funds instead.

"Two that do work well in conjunction are Thames River Japan and New Star International Japan Recovery."

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