The recent rally in Japanese equities will likely stabilise or reverse sharply depending on whether domestic institutional investors enter or refrain from the market, says Dutch fund house Robeco.

Japan's equity market is outperforming neighbouring Asian nations by a wide margin –  the Nikkei is up almost 40% year-to-date, compared with China’s benchmark CSI300 Index, which is down nearly 10%, and Hong Kong’s Hang Seng, down 7%.

While Robeco, which oversees €189 billion ($242 billion), is a firm believer that prime minister Shinzo Abe’s efforts to kick start the economy will be successful, its Asia-Pacific CIO Arnout van Rijn cautions that the stock market rally could reverse unless domestic institutions, notably pension funds, increase their domestic equity allocations.

Rijn notes that while Japan’s $1.4 trillion Government Pension Investment Fund, the third largest institutional investor in Asia, recently increased its allocations to domestic equity to 12% from 11%, it is still down from 13% in December.

Meanwhile, foreign investors have purchased ¥8 trillion ($80 billion) in Japanese equities in the first half of the year by Robeco estimates, although Rijn reckons this will be pulled at the first sign of volatility.

“All you see happening is that financial institutions [such as Japanese] banks and insurance companies are still reducing their portfolios in Japan,” says Rijn. He expects Japanese investors to be “the last ones to join the bandwagon” in 2014, by which time the market rally will have faded.

Regulation has pushed banks to reduce equity holdings, with Basel III requiring banks to hold a portion of their balance sheets in “easy to sell” assets such as bonds, in case of another financial crisis. Insurance companies similarly have been increasing allocations to bonds with long maturities in order to reduce volatility, Rijn adds.

If long-term minded Japanese pension funds increased their exposure to equities, however, Rijn says stock markets would stabilise, and in theory prevent the volatile sell-offs often experienced in markets such as Hong Kong, which are more reliant on retail investors.

The lack of large institutional investors in Hong Kong is the main reason for explosive equity markets in the Hang Seng Index, Rijn argues, noting that Hong Kong’s Mandatory Provident Fund’s participation in equity markets is negligible.

"At no point ever comes a moment where there is support from the demand and supply on the Hong Kong equity market because there are no real big institutional managers in Hong Kong,” he says.

While Abe’s plans to kick start the economy have its critics – US manager MFS Investment Management says Japan is 20 years too late  – Robeco is optimistic that the country’s aggressive monetary easing and structural reforms will boost the economy for the first time in two decades.

“A lot of Japanese are definitely believers that things are going to improve in Japan,” says Rijn. “Economics to a large extent are something that takes places in the minds of the consuming audience.”