It’s often said that stock markets always rise over the long-term; investors just have to be patient to make money. However, there is one massive exception to this rule – Japan.
Japan’s flagship index, the Nikkei 225, hit its all-time peak of 38,916 back in 1989, and there’s no sign of it going back to its former peak any time soon. Granted, the Japanese market had a strong run between 2012 and 2015, but long term investors who entered the market in 1989 will still have been caned. On top of that, economic performance since the early 90s has been pretty sluggish too.
That said, Japan has its plus points. The country is still a leader in technological innovation, and the government’s economic reforms, known as ‘Abenomics’ have delivered a modest boost to economic growth. The Bank of Japan’s QE programme has also boosted asset prices.
How to invest in Japan
A passive strategy makes a lot of sense for anyone who wishes to invest in Japan. That’s because most academic studies suggest that the Japanese market is pretty efficient.* In other words, share prices across the market accurately and quickly reflect all the information available at the time.
The more efficient a market, the harder it is for traditional active fund managers to deliver a market-beating return, so anyone investing in Japan should at the very least consider using passive ETFs.
Although the Nikkei 225 is the best known Japan index, the Topix is more representative of the Japanese stock market as a whole, so our main focus in this article will be on the Topix.
The index comprises more than 2000 stocks which are all listed on the Tokyo Stock Exchange. The index includes large and smaller companies. It’s calculated using the market capitalisations of its constituents with an adjustment for a company’s free float – the number of shares that are available for trading. By using the free float, cross holdings – where two companies own shares in each other – are excluded from the calculations. Cross holdings are very common in Japan. If you exclude cross holdings there’s no danger of double counting when you calculate the value of the index as a whole.
The index was launched in 1968 with a base level of 100 and hit a peak of 2884.8 on 18 December 1989 as the Japanese stock market bubble lost all touch with reality. Almost 20 years later in February 2009, the index was at just 909.
The biggest change in the composition of the index happened in 2005 when adjustments for free floats were introduced for the first time.
What’s in the index
The index is a broad reflection of the Japanese company and unsurprisingly is slanted towards electronics and cars.
Breakdown of Index (March 2016)
|Information & Communications||8.17%|
Source: Tokyo Stock Exchange.
Top ten constituents
|Company||Sector||Weight (% of index)|
|Mitsibushi UFJ Finance||Banks||2.07%|
|NTT||Information & Communications||1.86%|
|KDDI Corporation||Information & Communications||1.51%|
|Softbank||Information & Communications||1.51%|
|Sumitomo Mitsui Finance||Banks||1.35%|
Returns for Topix index
To July 2017. Source Morningstar
The Nikkei 225 is a better known index than the Topix but has two serious flaws for passive investors.
Firstly it’s a price-weighted index which means that a share with a Y100 share price will have twice as big a share of the total index than a stock with a Y50 share price. The market capitalisation of a company isn’t reflected in the make-up of the index at all.
Secondly, there are only 225 stocks in the index whereas the Nikkei’s rivals contain more companies.
This newer index launched in 2013 and was designed to encourage Japanese businesses to focus more on creating value for shareholders. Japanese companies have often been too conservative with all-powerful CEOs who are rarely challenged. Olympus is a good example of a Japanese company that suffered because too much power was in the hands of the CEO.
Constituents are selected using a range of criteria including market cap, return on equity (ROE) and corporate governance. A significant number of ETFs have been created round the world to track this index.
Adam Laird, Head of ETF Strategy, Northern Europe, at Lyxor says: ‘it’s too early to judge this index on performance. We should look at it on a 10-year horizon.’
Laird may well be right that it’s too early to give a definitive verdict now, but the early signs aren’t good – the index is under-performing the wider Japanese market. Gavekal Research suggests that the problem is the annual rebalancing of the index which happens every August based on results up to March 31 of that year. That gives arbitrageurs plenty of time to figure out which stocks are coming in or out of the index in August.
Stocks which are set to enter the index out-perform the market, boosting the TOPIX, but not the Nikkei JPX-400. If demand rises for JPX Nikkei-400 ETFs rise, this pattern may change, but it doesn’t look likely to change any time soon.
The FTSE Japan Index is similar to the TOPIX but has a lot fewer stocks. It’s based on market capitalisations but screens for free floats and liquidity are also applied. There are normally around 475 large and mid-cap stocks in this index.
Another option is the MSCI Japan Index which comprises around 320 large and mid-cap Japanese companies. It’s also based on free-float adjusted market capitalisations.
Both of these indices are widely used by some ETF providers but they don’t offer as much breadth across the Japanse stock markets as the Topix.
MSCI also operates a broader index which covers small cap Japanese stocks as well as larger companies – the MSCI Japan Investable Market Index, also known as the MSCI Japan IMI. It has over 1200 constituents and covers the vast majority of the stock market in terms of free float adjusted market cap.
Before we look at individual ETFs, there’s one final issue to consider – currency hedging. It’s all very well if your chosen Japanese index rises 30% over two years, but if the yen falls 20% against the pound over the same period, you’ll only make a 10% return rather than 30%.
And this isn’t a hypothetical issue. Between January 2012 and August 2015, the Nikkei 225 rose 147% while the yen fell 35% against the pound. So a sterling investor would have seen their profits cut back to something like 110% thanks to the falling yen. But an investor who put their money into a hedged ETF would have done much better and got closer to 147%.
On the downside though, hedged ETFs normally have higher management charges, and you shouldn’t assume that the yen will necessarily go against you over the next few years.
What the experts say
Adam Laird, Head of ETF Strategy for Northern Europe at Lyxor, argued that the Topix index is: ‘broad and more representative’ than the Nikkei 225 although the Nikkei ‘moves more than the Topix.’
He also accepted that the MSCI Japan and FTSE Japan indices are similar to the Topix in some ways but the Topix ‘has a size advantage. It goes right down the scale in a way that the FTSE and MSCI don’t.’
If investors choose the MSCI or FTSE indices, it may be because they want to focus on larger stocks or for ‘simplicity or consistency’ said Laird. If you’re investing in other regions tracking an MSCI index,you may wish to continue doing that in Japan.
Let’s now look at a range of Japanese ETFs that are domiciled in Europe and are compliant with European UCITS regulations.
1. Biggest ETF: iShares Core MSCI Japan IMI ETF GBP (LSE:SJPA)
This ETF tracks the MSCI IMI Index which means that it gives very broad exposure to the Japanese stock market. It’s also cheap with an ongoing charge of 0.2%.
The ETF is a physical optimised fund which means that it buys shares in companies in the index but doesn’t necessarily buy shares in every constituent in the index.
2. Cheapest ETF: Dbx-trackers Nikkei 225 GBP (LSE:XDJP)
The annual charge for this one is very low – 0.09%. That makes this ETF attractive even if the index – the Nikkei 225 – has its flaws. The fund is constructed using full physical replication.
3. Biggest Hedge: iShares MSCI Japan Hedged ETF GBP (LSE:IJPH)
This ETF is priced in pounds and has a currency hedge so that you are protected from any adverse movements in the yen/sterling exchange rate. However, this protection comes at a cost with an ongoing charge (OCF) of 0.64%. It tracks the MSCI Japan index and uses physical replication although there is some optimisation – in other words, it doesn’t necessarily buy all the constituents of the index. There’s also a version that hedges your investment to dollars, it’s ticker is LSE:IJPA.
4. Worth noting: Source STOXX japan exporters UCITS ETF USD (LSE:JPEX)
This is a Smart Beta ETF that tracks the STOXX Japan International Exposure Net Total Return Index. The index focuses on companies in the STOXX Japan 600 Index which earn at least 50% of their revenues outside of Japan. It delivered a 24.6% return in 2016. The annual charge is 0.35%.