TOKYO (Reuters) - Some long-term foreign funds are cutting exposure to Japanese stocks due to rising volatility and a high correlation to other markets that has made them less useful as a hedge to investors.
The more pessimistic view of Japan's stock market, revived by a run of poor economic data, has raised questions about the sustainability of a three-year long rally fueled by the stimulative effects of loose monetary policy or Abenomics.
"Macro drivers such as hopes of additional easing by the Bank of Japan and further depreciation of the yen, have become much weaker," said Yasuo Sakuma, portfolio manager at Bayview Asset Management in Tokyo. "Foreign investors could become net sellers of Japan stocks on an annual basis for the first time since 2008."
Japanese share prices have slumped since China's central bank devalued the yuan in mid-August, sparking fears of a hard landing in Japan's largest trading partner.
Two major European pension funds pulled money from asset managers they had mandated to manage Japanese stocks after the market turmoil in late August, asset firm executives told Reuters in recent interviews.
"The performance of our fund was pretty good. But we were told that they think the market's volatility is too high," said an official from an asset management firm with a mandate from a pension fund in Europe. The manager declined to be identified as he was not authorised to discuss investor contracts.
While the move by China rattled markets around the globe, a big rise in Japan stock market volatility has spooked investors.
The 60-day volatility of Topix .TOPX, the Tokyo Stock Exchange's benchmark index, shot up to 31 percent in late September, from around 13 percent at the end of June.
During the same period, the S&P 500 Index .SPX saw its volatility rise to just 22 percent from 10.5 percent.
The Topix's volatility surpassed Hong Kong's Hang Seng Index .HSI, which rose to 30 percent from 21 percent during the same period.
Rising volatility was due in part to Japanese shares being one of the world's best performing markets earlier this year, making it an easy target for profit-taking.
From the end of last year, the Topix rose 21 percent to an 8-year peak on Aug. 11, just before China devalued the yuan, but has since surrendered much of those gains.
Even so, the market has recovered faster than others and some foreign investors are returning.
TSE data shows foreign investors became net buyers of Japanese stocks in October, buying 526 billion yen ($4.35 billion), after four straight months of selling, during which they sold a total of 4.072 trillion yen.
Yet, October purchases were likely speculative, spurred by hedge funds and commodity trading advisers (CTAs).
Long-term investors looking to diversify risk are not jumping into Japanese equities because their correlation to other markets has risen so much, fund managers said.
Another major European pension fund that cut exposure to Japanese stocks cited the high correlation factor, said an asset management industry official with knowledge of the matter.
The 60-day correlation on three-day rolling returns between Japan and U.S. stocks rose to near 80 percent in late August and in early October, said Michiro Naito, executive director of equity derivative and quantitative strategies at JPMorgan.
That is even higher than previous peaks around 70 percent during the global financial crisis in 2008, or after the burst of the dot-com bubble in 2000, and is above the average of around 40 percent in recent years, he added.
From late 2012 to early this year, investors were buying Japanese shares because of Japan-specific reasons.
Though many investors now say they have to look beyond the broad themes such as stimulus and corporate governance reforms, some remain positive on Japanese equities.
"From our point of view, it just means that stock picking approach is becoming more relevant now," said Romain Boscher, global head of equities at Amundi Asset Management in Paris.
Editing by Jacqueline Wong