Japanese love for Brazilian funds faces test

The love affair between Japan’s individual investors and Brazilian assets has been an intense one over the past two and a half years.

It has led to an accumulation of nearly Y8,000bn ($104.3bn) of investments in mutual funds related to Latin America’s largest economy, according to Lipper, the fund tracker.

But questions are now being raised over the longevity of the relationship.

These funds have been dealt a double blow. The recent risk aversion has led to a sell-off in emerging market and other assets. There has also been a surge in the yen to fresh postwar highs against the US dollar and a fall in the Brazilian real.

Analysts say many Japanese investors are likely facing unrealised losses from their emerging market investments.

The initial attraction of Brazilian funds, which did not exist in Japan before the Lehman crisis in 2008, is clear. The promise of a fast-growing economy set to benefit from hosting the football World Cup in 2014 and the Olympics in 2016 was a tale too alluring and too familiar to pass for the Japanese, recalling their own country’s 1960s growth story.

The huge interest rate differential between the two countries (0-0.1 per cent and 12.5 per cent) only added to the draw.

However, between the end of June and August 12, all but six of the 111 Brazil-themed funds for Japanese investors have had shrinking net asset values, according to Lipper.

While Japanese investors had been shifting out of Brazilian stocks for about a year – leading to a decline in equity fund NAVs – they had been moving into currency overlay funds instead, Lipper says. These are funds where the underlying assets are usually not real-denominated but US dollar high-yield bonds, real estate or commodities.

But to give an additional boost to returns, the funds invest in the real through non-deliverable forwards (NDF) – derivatives that allow investors to speculate on a local currency from offshore.

These account for at least Y5,500bn of the total funds, Lipper says, and the NAVs on 47 out of 67 of those funds have fallen by 10 per cent or more between the end of June and August 12.

The sheer amount of Japanese investment in these funds means it could have a significant effect on the Brazilian real NDF market if there was a sudden sell-off because recent measures by Brazil to halt the rise of the real has worsened liquidity in the market, analysts said.

“Market players have become nervous as it could impact on NDF markets,” says Junya Tanase, a currency strategist at JPMorgan.

For Masatsugu Yamamoto, a senior fund manager at Diam Asset Management, the biggest concern is if global risk aversion severely worsens and sends the yen to levels around Y60 against the dollar.

“The main point clients are watching now is if their NAVs fall [further] because of the strong yen,” Mr Yamamoto says.

His Y100bn currency overlay fund still has daily inflows of Y300m. “There are contrarian investors [buying on dips] at the moment.”

While the yen has not risen that far yet, risk aversion looks set to continue, suggesting a slowdown in the number of new investors into these funds.

Bank of Japan data show that households have been increasing their deposits at banks since even before the March 11 earthquake and tsunami.

Brazil’s introduction of measures to halt the rise in the real has also put some investors off.

Mr Tanase says a decline in the Nikkei 225 Average below 8,705 could potentially trigger some unwinding of emerging market investments.

But an en masse sell-off is unlikely as traditional Japanese mutual fund investors, mainly pensioners, are prepared to sacrifice their underlying investment in favour of high monthly dividends, adds Mr Yamamoto.

For these currency overlay funds, the monthly dividend a share can be as much as Y200 compared with Y35 for Kokusai Asset Management’s global sovereign bond fund, according to Lipper.

The Brazil story remains intact, Mr Yamamoto adds. “If investors were worried about Brazil itself, then its sovereign bonds would be selling off but that isn’t the case.”

Japan’s small investors appear to be moving into a steadier phase in its relationship with Brazil. But in this marriage, there could be some rocky patches ahead.