For much of the past two decades Japan has been an underweight position in both institutional and private investor portfolios. This portfolio stance has been vindicated by the performance of the Nikkei 225, the country’s best-known equity index, which has fallen from an all-time intraday high of 38,957 on 29 December, 1989, the peak of the Japanese asset price bubble, to a low of 7,056 on 10 March, 2009, the nadir of the global financial crisis.

The latest BofA Merrill Lynch Survey of Fund Managers found that managers of Japan funds were the most bullish, with a net 91% saying that Japan’s economy will strengthen, up from a net 47% two months ago.

This mammoth drawdown (down 81.9% peak to trough), coupled with a deflationary and seemingly moribund economy, rightly scared many investors away. And while the Nikkei had recovered to 8,455 by year-end 2011, a gain of almost 20% from its financial-crisis low, it still lagged other major markets which had rebounded by far bigger margins. All in all, Japan’s equity market justified its perennial underweight status.

This could, however, be about to change. In the latest BofA Merrill Lynch Survey of Fund Managers, managers of Japan funds were the most bullish with a net 91% saying that Japan’s economy will strengthen, up from a net 47% two months ago. The Nikkei’s stellar performance year to date, up 21.3%, suggests they are putting their money where their mouths are. Japan, it seems, deserves another look.

A number of factors are behind this dramatic shift in sentiment. According to Yoshito Sakakibara, Japan economist and strategist at JPMorgan, the trigger for Japan’s outperformance this year was the additional monetary policy easing by the Bank of Japan (BoJ) on 14 February. Sakakibara believes the Japanese monetary authorities – the Ministry of Finance (MoF) and the BoJ – now look united in their desire to see a softer yen and in their determination to keep interest rates low.

The BoJ’s statement expressing its ‘determination’ to overcome deflation and achieve sustainable growth with price stability (defined as a core inflation rate of 1%) is a meaningful change of language from the previously stated ‘understanding’. In addition, this statement was accompanied by a second round of broad asset purchases known as ‘comprehensive monetary easing’.

This policy action may have lasting implications for the markets, reckons Sakakibara. The aggressive JPY 10 trillion increase in Japan Government Bond (JGB) purchases is likely to cause the BoJ to move up the yield curve. As such, the market is coming to recognise that the BoJ is acting along similar lines to the Fed. Meanwhile, the MoF has dropped its opposition to a virtual inflation “target”.

A more assertive set of anti-deflation policies should help boost the domestic economy, stoke a degree of asset reflation and precipitate a weaker yen. All three are positive for corporate earnings and hence for the stock market as a whole.

The eventual return of inflation to Japan would yield a further set of benefits. According to Edinburgh-based Martin Currie Investment Management, domestic institutions have been long-term buyers of bonds and sellers of equities, essentially since the Japanese bubble burst in the late 1980s. During a prolonged deflationary period, this is a very sensible allocation of assets – the real value of the bond coupon grows at the same time as corporate earnings and equity valuations are under pressure. This has resulted in the persistent domestic selling of equities. Take deflation away and the constant drag on the market is removed.

There are other positive signs too, with analysts expecting a rebound in manufacturing activity. As a result of the natural disasters in Japan and Thailand and economic concerns across the globe, industrial production in Japan was severely affected. This meant that companies came into 2012 with inventories at low levels. Combine those low inventories with signs of recovering demand in the US and only a moderate slowdown in Europe (less than expected) and you have the hallmarks of a rebound in manufacturing activity.

Factor in the productivity gains companies have been forced to make in response to the stronger yen, and the outlook for corporate profitability and thus Japanese equities looks rosy. All this corroborates the IMF’s forecast that the Japanese economy will grow by 1.7% in 2012, compared to average of 1.2% for advanced economies. After decades in the cold, Japan is finally back on investors’ radars.

For investors seeking exposure to Japanese equities, there are a number of London-listed ETFs to choose from, tracking a range of indices. There are also some interesting foreign-listed (NYSE, TSX) ETFs worth considering for more specialist exposure.

Equity ETFs

The following six funds track the MSCI Japan Index. The MSCI Japan a free-float adjusted market-capitalisation weighted index designed to track the equity market performance of Japanese securities listed on Tokyo Stock Exchange, Osaka Stock Exchange, JASDAQ and Nagoya Stock Exchange. The index covers 85% of the investable market. The index currently has 315 constituents.

HSBC MSCI Japan ETF (HMJP) TER 0.40%

MSCI Japan Source ETF (MXJP) TER 0.45%

Amundi ETF MSCI Japan (CJ1) TER 0.45%

Credit Suisse MSCI Japan (CSJP) TER 0.48%

DB X-trackers MSCI Japan TRN Index ETF (XMJP) TER 0.50%

iShares MSCI Japan (IJPN) TER 0.59%

The following two funds track the MSCI Japan Small Cap Index. The MSCI Japan Small Cap Index offers exposure to Japanese small-cap stocks which rank below the MSCI Japan Index measured by market capitalisation and comply with MSCI’s size, liquidity, and free float criteria. The index currently has c. 600 constituents, comprising (approx.) the smallest 15% of the total investable market by market capitalisation.

Credit Suisse MSCI Japan Small Cap ETF (CJPS) TER 0.58%

iShares MSCI Japan SmallCap (ISJP) TER 0.59%

Credit Suisse MSCI Japan Large Cap ETF (CJPL) TER 0.48%
The MSCI Japan Large Cap Index offers exposure to Japanese large-cap stocks, those comprising approximately the top 70% of the total investable market by market capitalisation. The fund currently has 141 constituents.

Lyxor ETF Japan Topix (LTPX) TER 0.50%
The Tokyo Stock Price Index (Topix) includes all First Section (market place for stocks of larger companies) listed shares on the Tokyo Stock Exchange. The index is free-float adjusted market capitalisation-weighted and currently has 1,665 constituents.

Credit Suisse Nikkei 225 (CNKY) TER 0.48%
The Nikkei 225 Index is comprised of 225 highly liquid large-cap stocks traded on the first section of the Tokyo Stock Exchange. Constituents are given an equal weighting based on a par value of 50 Japanese Yen per share, whereby the prices of stocks with other par values are adjusted to also reflect a par value of 50 Japanese Yen per share.

DB X-trackers S&P Japan 500 Shariah ETF (XSHJ) TER 0.50%
The S&P Japan 500 Shariah Index is Shariah-compliant version the S&P Japan 500 designed to represent the Japanese investable market. Index constituents are drawn from companies listed on the Tokyo, Osaka, or JASDAQ exchanges. Constituents represent the large-, mid- and small-cap components of the Japanese equity markets. The index currently has about 280 constituents.

Currency ETCs

Sophisticated investors might wish to consider a currency short play on the yen.

ETFS Short JPY Long GBP ETC (JPGB) TER 0.39%
ETFS Short JPY Long GBP (JPGB) is designed to track the MSFX Short Japanese Yen/GBP Index (TR) which aims to reflect movements in exchange rates between the two currencies, and exposure to an interest rate differential.

ETFS Short JPY Long USD ETC (SJPY) TER 0.39%.
ETFS Short JPY Long USD (SJPY) is designed to track the MSFXSM Short Japanese Yen Index (TR) which aims to reflect movements in exchange rates between the two currencies, and exposure to an interest rate differential.

North America listed funds

SPDR Russell/Nomura PRIME Japan ETF (NYSE:JPP)

SPDR Russell/Nomura Small Cap Japan ETF (NYSE:JSC)

WisdomTree Japan Small Cap Dividend ETF (NYSE:DFJ)

Claymore Japan Fundamental Index ETF (TSE:CJP)