Japanese equities have been on quite a tear this year due in large part to overseas investors re-weighting the country in their global equity portfolios. However the rally in Japanese equities has come in spite of serious weakness of the Japanese yen. Martin Fackler in the New York Times reports that this may be due in part to a new found appetite for risk by individual Japanese investors.

Analysts said the yen has fallen as Japanese investors, particularly individuals, shift money into foreign securities to get higher returns from rising interest rates in the United States and, recently, Europe. To make such investments, Japanese investors must buy dollars and euros by selling yen, driving down the Japanese currency’s value.

Still, analysts said it was surprising that the yen had declined so much, given the underlying strength of the improving Japanese economy, which is looking its healthiest since the early 1990’s.

As the economy strengthens and investors become more confident they are investing capital overseas at a rate not seen in some twenty years. This comes at the same time that foreign investors find the domestic Japanese equity market increasingly attractive.

Timothy Middleton in MSN Money jumps on the Japanese stock bandwagon despite some trepdiations.

Japan could crater again. But I don’t think so. This time, the rally is different.

The end of deflation has lead to seemingly self-sustaining economic growth. The Yen has come down which has helped Japanese exports, but has hurt unhedged equity investments held by foreigners.

Thankfully for individual investors there are plenty of open-end, closed-end and ETF options for investment. According to Middleton, if Japan gets re-weighted in global equity portfolios it could be another good year in 2006 for Japanese equities.

Chet Currier at Bloomberg.com sees some worrying signs in the massive inflows into international equity funds. A 41% increase in inflows in 2005 has pushed assets in international assets over the $1 trillion mark.

While the inflows do have a whiff of trendiness about them, there is an upside as well. This demonstrates that Americans ‘home country bias’ may indeed be reversing. For some time financial advisors have been advocating investors have more globally diversified portfolios, and these inflows may simply be a continuation of this trend. However a dose of skepticism may be in order:

“Inflows to international equity funds in 2005 exceeded those to U.S. equity funds,” Nachmany said. “Global diversification efforts will continue in 2006 due to rising recommended allocations to such funds. Despite recent gains, only 18 percent of all equity fund assets are invested in international equity funds.”

That last figure suggests that investors haven’t gone overboard yet on their allocations to international stocks — they’re just catching up after a long period of lagging interest. In the vast global economy of the future, all other nations beyond U.S. borders are surely going to account for more than 18 percent of the action, aren’t they?

Japan represents a significant part of the equity markets outside of the United States. As of September 30, 2005, Japanese equities made up 23.5% of the MSCI EAFE Index (EFA), behind only the United Kingdom. A continued rally in international equities will therefore be driven in part by the strength of the Japanese equity market (and the Yen). Most individual investors are best served by avoiding single-country funds, but knowing why and how the Japanese market moves is important to informed investors.