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Fund managers set their sights on unloved Japan

After what has been a difficult start to the year for Japanese equities, being the only developed market to lag in the first half of 2014, fund managers are now upping their allocations to the sector as domestic buyers have started to weigh in.

Year-to-date the Nikkei 225 is off 5.7 percent – it has already recovered some ground from year-to-date falls of as much as 14.6 percent in April -- and the Topix is 1.65 percent lower.

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Tomohiro Ohsumi | Bloomberg | Getty Images

The figures are bleak in comparison to the near 7 percent gains seen in the S&P 500, the over 8 percent rise for the Nasdaq and the Dax's almost 4 percent climb.

Current economic data coming from Japan has been distorted by a rise in consumption tax, which has affected inflation, retail sales and industrial production, analysts have said. Strong corporate earnings have failed to lift markets.

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Chief investment strategist at JPMorgan Private Bank Cesar Perez said this was in part down to macro fund managers selling out of the region after a fresh round of monetary easing did not materialize in April after the sales tax hike.

"All macro managers that bought Japan, bought it on a vision that we are going to get more quantitative easing from (Bank of Japan governor) Kuroda and we haven't got it," he said.

"It looks like a market where there is potential, more importantly I am starting to see something which is very positive; all the macro guys that got in are starting to get out. Finally I am starting to see in the last few months, the first domestic buying I have seen for years," said Perez.

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The breakdown in the correlation between Japanese stocks and the U.S. 10-year Treasury was also another good sign, Perez said and he is currently looking to bolster the position in the region.

May and June marked the first "properly positive" months for Japanese stocks since December of last year according to Steve Russell and David Ballance, fund managers at wealth manager Ruffer, who said they remain "entirely enthused" on the country's outlook.

The lack of additional monetary policy may disappoint some "fast-money" investors but lays the ground for further growth in corporate earnings, the pair said.

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"Japan's recovery story is not as full of hope as it was at the end of 2012 when a revitalized Shinzo Abe returned to power on high hopes of a vigorous reforms agenda," said U.K. chief investment officer at Coutts, Alan Higgins.

Valuations in the Topix index of Japanese shares a currently "neither hot nor cold," said Higgins, who remains neutral on Japanese equities.

But for firms likely to benefit from the revival of inflation in Japan's economy, he sees plenty of upside, "most notably property companies, banks and brokers," he added.