Over the past decade or so, there have been countless studies and articles on the inability of active portfolio management to reliably add value versus market benchmarks, even before accounting for fees. However, most of the research tends to focus on US markets, particularly US large-cap equities, and glosses over (or ignores altogether) the reality that there are other market categories where active managers have, in fact, had a great deal of success historically (and may continue to do so). The inefficient Japanese equity market is a prime example.
A good fishing pond
The proof of the pudding is in the eating (Figure 1). In 70% of rolling three-year periods over the past 20 years (ended 31 December 2020), at least 60% of active Japan equity managers — in some years, substantially more than that — have outperformed their respective benchmarks. By contrast, and as expected, most US large-cap equity managers have struggled to consistently top their benchmarks, with 60% or more delivering excess relative returns in only 25% of the rolling three-year periods.
One potential takeaway from this analysis is that Japanese equities offer numerous attractive opportunities for active portfolio managers to add value in the form of alpha generation. We strongly believe this to be so and like to think of Japan’s market as a well-stocked “fishing pond” for active managers to ply their trade. Of course, to extend that metaphor, it’s not enough to have a pond that’s teeming with fish if the fisherman himself is not proficient or doesn’t use the right bait. In other words, skilled, discerning active managers will be much more likely to capitalize on a compelling opportunity set than their less capable counterparts.
Efficient vs inefficient markets
So what makes Japan equity, or any market for that matter, a good “fishing pond”? In our view, much of it comes down to the market’s degree of efficiency (or lack thereof). The more efficient the market, as US large-cap equity is generally acknowledged to be, the more challenging it will likely be for active managers to outperform benchmarks that serve as proxies for the overall market. Conversely, in the case of less efficient or even inefficient markets (like Japan’s), there is greater alpha potential, due to the breadth and depth of the opportunity set — with many of those opportunities being overlooked or underappreciated and, therefore, mispriced.
Wellington’s Fundamental Factor Team has developed several key metrics to gauge a market’s level of efficiency (Figure 1). In recent years, Japan equity has registered low scores on all of them, making it one of the world’s most inefficient major markets. On the “consensus” metric, for example, Japan’s market exhibits one of the largest magnitudes of dispersion for earnings forecasts and “event surprise.” The often sizable gap between companies’ announced earnings and consensus expectations can create significant opportunities for investors to anticipate and exploit such dispersions by thoroughly researching company-specific fundamentals.