Japan's Mutual Funds: Picking Your Moment

It has been five years now, and you still have to scrape Japanese mutual-

fund returns off the pavement with a spatula. But if you hold these hapless funds, a turnaround may lie ahead. If you haven't yet invested in Japan, this might be a chance to get in at the bottom.

A long-term bear market, a banking crisis, and a rising yen, which crippled exports, have all battered Japan's economy. Throw in the Kobe quake and the cult bombings, and you have a real disaster. The Tokyo market has hit two false bottoms in the past four years--when it briefly rallied, only to fall again. Now, it's down some 60% from its 1989 peak. Barton Biggs, chief economist at Morgan Stanley, thinks there's a 70% probability the worst is over: "Now's the time to jump into Japan."

HIGH YEN. But any move should be toe-first. "My concern is that we could see a repeat of [the previous rallies], and the real measures to stimulate imports and restructure industries won't be followed through on," says Paul Kirby, manager of GAM Japan Capital Fund. Still, Japan is making some headway. Most analysts agree it will solve its banking crisis. It has cut interest rates, increased liquidity, and launched a public-works program to stimulate growth. While stocks are still on the pricey side, more bargains are appearing. "Valuations have never been more attractive," says Shigeki Makino, manager of the Fidelity Japan Fund. Also, Japanese companies have been restructuring and cutting costs--progress that has been masked by a high yen.

Most fund managers are bullish on electronics: Companies such as Sony, Sharp, and Hitachi will be profitable again if the yen stabilizes, predicts Chris Wendler, vice-president of Rowe Price-Fleming International. He also likes discount retailers such as Seven-Eleven Japan, which is part of a retailing revolution from mom-and-pop stores to discount houses. And he thinks companies in basic industry may benefit from public-works initiatives.

Warburg Pincus Japan OTC focuses on small outfits. Its theory: Japan's big conglomerates are losing out to smaller, nimbler rivals that produce offshore and undercut their prices. Take Nihon Jumbo. By importing chemicals, it develops film for half the price of Fuji Photo Film, which is locked into domestic suppliers. Japan OTC, down 16% through July 26, is buying small electronics producers such as I.O. Data, which makes computer boards. Such companies are "ridiculously cheap," argues co-manager Nicholas Horsley, but their products are in great demand.

If you're worried about yen fluctuations, GAM's Kirby hedges to the dollar to eliminate currency risk. But betting on currencies is itself risky. This year, such funds lost out on gains from the yen's appreciation. Right now, Kirby is somewhat cautious: He has 18% of assets in cash. GT Global Japan Growth is controlling risk by keeping one-third of the portfolio in bonds. Its stock holdings are concentrated: 5% of assets are in DDI, a cellular-phone company, for example. Recently deregulated, that market is exploding, says Christian Wignall, chief investment officer of GT Global Mutual Funds.

You could buy dollar-denominated American depositary receipts of Japanese companies, but mutual funds offer experienced management in an arcane market where commissions are high. And they lower risk by diversifying. The oldest Japan fund, Scudder's Japan, has logged a 12.86% annualized return for the past 10 years, but returns have been negative for the past 5 years. The best course may be to watch for signs that the government is creating long-term economic solutions and then use dollar cost averaging to buy in. But brave souls who jump in now should expect a rough ride.

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