Is Mother the answer to Japan’s strange markets?

As we detail in the current issue of Investment Adviser, the yen’s surge has caught out plenty of investors who had backed the latest Abenomics stimulus programmes to push Japanese equities higher again this year.

Because when the yen goes up, Japanese stocks head in the other direction. Those buying hedged share classes won’t even have had the solace of seeing these market falls offset by currency gains.

The currency’s 10 per cent year-to-date rise against the dollar (13 per cent against sterling) wasn’t exactly the predicted reaction to the introduction of negative interest rates. Another development that’s been surprisingly tough to predict is the performance of the Legg Mason IF Japan Equity fund, run by Hideo Shiozumi.

Mr Shiozumi, whose strategy can be euphemistically described as “high octane”, is a manager who makes the kind of bullish prediction which must seem almost quaint to the crisis-weary fund buyer: Nikkei at 25,000, Nikkei at 30,000, Nikkei through the roof.

The Mothers Index is the secret to Mr Shiozumi’s success

In the past, this philosophy has meant significant outperformance in the good times, and sharp reversals when sentiment turns. But lately this pattern has broken down.

Take this year: The Investment Association’s Japan sector has lost 0.8 per cent so far in 2016, currency gains just about making up for indices’ struggles. Mr Shiozumi, by contrast, is up 33 per cent. Biotech company Peptidream, the manager’s top stock at more than a tenth of his portfolio, is up 70 per cent alone.

Here lies the secret to the manager’s success. Peptidream is a microcosm of what’s happening in the high-growth, small-cap Mothers index – even if the company itself is now too big for inclusion in this benchmark.

Abenomics may be viewed with increasing scepticism by some investors, but one of its reverberations is still shaking things up: small caps are still outperforming large caps. The Mothers index has risen 35 per cent this year in local currency terms; Japan’s main Topix index is down 15 per cent over the same period.

Mr Shiozumi is clearly onto some winners here. These smaller companies, targeting domestic markets, have the added benefit of being less affected by moves in the yen.

Is this, after all, the best way to play Japan’s changing economy? Well, perhaps. But returns going vertical should always be a reason for nervousness.

Biotechnology still makes up a sizeable proportion of the small-cap benchmark. Investors are already familiar with the fluctuations in Western stocks of this kind. They could yet find that the index is the Mother of pitfalls, not pearls.

Dan Jones is editor of Investment Adviser