Do ETF investors have enough tools to capture Japan?

Gaps in the product line-up, wide fee and return disparity and 80% BoJ ownership plague Japan ETFs

Jamie Gordon


The headline Nikkei 225 index is at a 30-year high as investors turn their focus to the world’s third-largest economy, however, there are significant gaps in the current range of Japan ETFs listed across Europe.

The continent’s largest Japan ETF, the $4bn iShares Core MSCI Japan IMI UCITS ETF (SJPA), has shot up 15.2% so far this year, as at 15 June, prompting global investors to pile over $1.9bn into Japan ETFs in May alone.

Hal Cook, senior investment analyst at Hargreaves Lansdown, explained Japanese stocks have acquired star-studded status following a combination of banking sector shocks and a concentrated tech rally in the US, pushing multi-asset investors to increase their positions in the country’s equities.

“The combination of relatively strong economic data – GDP growth for Q1 was recently upgraded to 0.7% – inflation appearing to be a bit sticky – it increased between March and April where other countries are seeing declines – continued ultra-loose monetary policy and ongoing corporate governance reform all seem to be coming together to give appeal to investors,” Cook added.

Challenging the idea of this being another false dawn, star investor and Berkshire Hathaway chairman Warren Buffett travelled to Japan in April and confirmed he had increased his positions in Japanese companies. Japan equity managers have also spoken out on the increase in net inflows from existing clients and potential client enquires, Cook said.

Japan ETF offering

Regardless of whether the country’s recent rally is a flash in the pan or more substantive run of form, fund selectors, including Premier Miton fund manager Wayne Nutland, argue the ETF arsenal is not well-developed enough to allow investors to maximise returns.

First, he suggests there is a dearth of factor and systematic ETFs for Japanese equities.

“Japan is well known for exhibiting several unusual characteristics compared to the rest of the world. For instance, a large number of companies with low valuation metrics, low levels of gearing, profit margins and ROE with room for improvement,” Nutland said.

“It would seem to be a market with scope for factor or systematic strategies but they’ve yet to emerge, at least in UCITS form.”

While there are nine Europe-listed ETFs capturing the value factor for US equities, there are none for Japanese stocks.

Nutland also added identified currency movements as an area of opportunity. While the yen has useful diversification benefits by strengthening during risk-off periods, Japanese equities tend to rally during periods of yen weakness, with currency-hedged Japan equities outperforming during bull periods and underperforming on the downside.

This year, Japan ETFs hedged to a pro-cycle currency such as sterling have generated significant outperformance. The $223m WisdomTree Japan Equity UCITS ETF – GBP Hedged (DXJP), for example, has returned 37.2%, the strongest performance of any Japan ETF so far in 2023.

However, DXJP’s 0.45% fee is nine times higher than the cheapest Japan ETF, with the $250m Amundi Prime Japan UCITS ETF (PR1J) charging just 0.05%.

“Probably due to a lack of global investor interest over recent years, the UCITS ETF landscape is less developed for Japanese equity ETFs than for other equity regions,” Nutland continued.  “There are fewer products, assets under management (AUM) are smaller and fees are somewhat higher, especially for currency-hedged products.”

The equity market horizon

However, this is not to say ETFs are not already playing a significant role in the market. In fact, the Bank of Japan (BoJ) currently has amassed $379.5bn of domestic equity ETF holdings since 2010 as part of its monetary policy strategy.

By 2021, the central bank made up 80% of all assets parked in Japan equity ETFs, equivalent to 7% of Japan’s total $6trn stock market at the time.

When the BoJ announced it would switch to exclusively buying TOPIX-tracking ETFs and halt buying Nikkei-tracking ETFs, the Nikkei 225 dropped 6.1% in a day without the monetary policymaker actually making any trades.

Therefore, it should come as little surprise that some onlookers are paying close attention to a recent proposal by Japanese finance minister Shunichi Suzuki, who at a G7 meeting in May called on the government to buy the BoJ’s ETF stockpile as a means of “securing sources of revenue”.

Suzuki proposed buying the ETFs at book price – a $114bn reduction on current market price – with the aim being to distribute wealth to young Japanese citizens to counteract the country’s age-wealth gap.

Whether the ETFs are sold for revenue to be distributed or holdings are passed to citizens to use at their discretion, it bears considering what impact potentially hundreds of billions of dollars of redemptions could have on underlying markets.

“Japan is cheap and the US is expensive but it has been that way for a while,” Peter Sleep, senior investment manager at 7IM, said. “The overhang of the government's shares is a negative.”

He also underlined how deflated Japanese stocks remain versus the Nikkei 225’s true bubble moment in 1989. When the index peaked at 38,957 points, Japan's equities comprised 50% of global market cap, versus less than 7% today.

“This suggests that there is room for a bounce back,” he continued. “However, Japan only represents 4% of global GDP and the case for a bounce back is not clear cut.”