I like Japan. I think it's arguably the most attractive stock market in the world right now. Later in this piece, I'll highlight five Japanese ETFs that I think worth considering for your portfolio, but first, I want to say why I'm so positive about the Land of the Rising Sun.
The first point is that Prime Minister Shinzo Abe's economic reforms have been making a difference. Especially in corporate governance. A new governance code was introduced in 2015 and at that point most Japanese firms had no independent directors. Now 85% of Japanese firms have at least two. That's good news for shareholders - independent directors should force companies to stay focused on what their investors want.
The new shareholder-friendly approach could also boost dividends. There's certainly plenty of scope for higher dividends as Japan's payout ratio - the percentage of earnings paid out in profits - is still relatively low at 30%. (It's more like 50% in Europe.)
What's more, cross shareholdings - where two or more companies own shares in each other - are being unwound. These two developments mean that return on equity (RoE) is being boosted. According to the FT, RoE is up from 5% in 2011 to 8% now. That means that companies are getting a better return from the capital that's been invested. Profits are being boosted too. That has to be good news for shareholders.
We're seeing positive signs in the wider economy too. Total employment is close to a record high and unemployment is now just 2.3%. A tighter labour market should mean that wages will pick up, leading to higher prices. For a country that has suffered several bouts of deflation over the last 30 years, a bit of inflation is a welcome development.
Admittedly, when you look at valuation, Japan isn't in bargain basement territory. Japan's cyclically adjusted price/earnings ratio (CAPE) is currently 25, much higher than 17 for the UK. On the other hand, that figure of 25 is lower than the historical average for Japan, and I'd argue that there's plenty of scope for decent earnings growth as the positive developments I've outlined boost business further.
Don't get me wrong, I'm not saying Japan is a sure thing. The country has its problems - perhaps the biggest is an ageing population. And if, as seems likely, markets are turbulent in 2019, Japan won't escape the volatility. Japan is a big exporter and could be badly hit if the Trump trade war gets worse. But, in spite of that, if I was going to invest fresh money into stocks and shares right now, I'd put a fair old chunk into Japan. And for what it's worth, a sizeable portion of my current portfolio is already invested there - around a fifth.
So let's now look at my five top Japan ETFs:
Xtrackers Nikkei 225 UCITS ETF (GBP) XDJP
The big attraction of this ETF is that it has a super-low charge of 0.09% a year. That's why it's in the list.
There are a couple of downsides though. Firstly, the ETF tracks the Nikkei 225, the best known Japanese stock market index which comprises 225 leading Japanese companies. With only 225 companies in the index, you're not going to get any exposure to the smallcap end of the market.
Secondly, the Nikkei is 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. That means the weighting of a stock in the index is a bit of a lottery.
That said, market-cap weighting has its critics. The big problem is that investors end up with more and more exposure to the largest companies, and that exposure rises further if the valuation gets too high. In other words, a market-cap weighted index may be slanted towards the most expensive stocks in the index. You don't have that problem with this Xtrackers ETF.
Lyxor Core MSCI Japan UCITS ETF GBP | LCJP
If you'd like to invest in a conventional passive ETF with market-cap weighting, then this Lyxor ETF is a good one to go for, as it's nice and cheap with a 0.12% annual charge. It tracks the MSCI Japan index with is a bit broader than the Nikkei with around 320 stocks. The index is based on free float market-cap which means that cross shareholdings are excluded from the market caps when the stocks are weighted for the index.
iShares Core MSCI Japan IMI UCITS ETF GBP | SJPA
This ETF gives you more broad exposure to the Japanese market. It tracks the MSCI Japan IMI index which comprises around 1200 stocks including plenty of smallcaps. In fact, it covers about 99% of the Japanese market by value. It's also free float market-cap weighted like the Lyxor ETF.
The annual charge is a touch higher at 0.2% a year but you may think that's worth paying for the extra breadth you get here.
Invesco JPX-Nikkei 400 UCITS ETF (GBP) S400
This ETF tracks the JPX-Nikkei 400 index which was launched in 2013. It was designed to encourage firms to improve corporate governance, and companies are selected using a range of criteria including market cap, RoE and corporate governance.
Sadly the performance of the index has been disappointing so far - that may be because it's especially vulnerable to arbitrageurs. It's rebalanced every August based on company results up to March 31st. That means there's plenty of time for traders to spot which companies are going to come in and out of the index and make their moves.
Still, it's an interesting idea for an index and it very much chimes with the changes we're seeing in Japan. So we may see an improvement in performance over the longer term. This particular ETF is also pretty cheap with an ongoing charge of 0.19% a year. That prospect of improved performance gets in my 'top five.'
iShares MSCI Japan Small Cap UCITS ETF (GBP) ISJP
This ETF tracks the MSCI Japan Small Cap Index which comprises smaller Japanese companies that aren't included in the larger MSCI Japan index. It is pricier with a 0.58% charge.
If you're particularly keen on getting exposure to smaller Japanese companies, I'd suggest that you should also consider some investment trusts as well as ETFs. In particular, the Baillie Gifford Shin Nippon Trust and the JP Morgan Japan Smaller Companies Trust.
I'm highlighting investment trusts here because I think there are real opportunities for active stock-picking managers to beat the market in this area. I should add that the Baillie Gifford trust currently trades at a premium to its net asset value - in other words, its share price is higher than the value of its underlying portfolio. But I'd argue that just reflects the quality of the trust, and even with this premium, I still think the trust is worth considering.
When I first invested in Japanese ETFs, I went for a hedged ETF. That took the currency risk out of the equation. In other words, if the Japanese market went up by 10%, my ETF went up by roughly 10% regardless of what happened to the yen.
There are plenty of hedged Japan ETFs out there if you want to go down this road. One example is the iShares MSCI Japan GBP Hedged UCITS ETF | IJPH. It tracks the MSCI Japan index with a hedge. Trouble is, the currency hedge is expensive - the ETF has a charge of 0.64% a year. And I'm also not convinced that the yen is going to be a big faller over the next couple of years.
Anyway, that's my round-up of five Japan ETFs. The choice is yours!
For more ETF ideas, read Four top emerging markets ETFs and Five top Europe ETFs. And for more on Japan, read Why I still like Japan ETFs