Interactive Investor

Japan’s stock market: the basics every investor should know

Japan’s stock market is too big and too important for investors to ignore, explains Tom Bailey.

25th September 2020 14:23

by Tom Bailey from interactive investor

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Japan’s stock market is too big and too important for investors to ignore. Tom Bailey outlines the key details. 

Japan is the world’s third-largest economy and one of the world’s largest stock markets.

Japanese equities account for around 7% of the MSCI All-Country World Index, the second-largest weighting after the US. Meanwhile, it is home to some of the world’s most famous companies and has, historically, been a pioneer in new technological and business techniques, from just-in-time delivery methods in the 20th century, to today’s robotics and automation.

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As a result, Japan is somewhere investors cannot afford to ignore. Below, we outline the key characteristics and details of the Japanese stock market that all investors should know.

The main indices

The most well-known Japanese stock-market index is the Nikkei 225. Investors are most likely to see this index quoted in the financial press and used as a general gauge of the health and outlook of Japan’s economy and stock market. As the name suggests, this tracks the 225 largest stocks listed in Japan.

However, while the index is famous, it is rarely used by UK investors to gain exposure to the country, with most exchange traded funds (ETFs) and index funds tracking different indices.

The principle reason for this is that the Nikkei 225 is price-weighted, not market-capitalisation-weighted. In a price-weighted index, the trading prices of stocks determine how much of the index they comprise. Many investors view this method of weighting as inferior to market capitalisation. As a result, the index is not tracked by many ETFs or index funds. One way to track this is the iShares Nikkei 225 ETF JPY Acc GBP (LSE:CNKY). However, it has a relatively steep charge of 0.48%. A cheaper option is the Xtrackers Nikkei 225 ETF 1D GBP (LSE:XDJP), with a charge of just 0.09%. 

Another well-known index is the TOPIX. This index is market-capitalisation-weighted and is also often cited in the media as a key metric for the performance of Japan’s economy and stock market. However, as with the Nikkei 225, it is rarely used by UK investors to track the Japanese market.

Perhaps the most popular Japan index for investors in the UK is the MSCI Japan index. This index has just over 320 constituents and covers around 85% of the entire universe of listed equities in Japan. As you would expect, iShares offers several ETFs. The iShares Core MSCI Japan IMI ETF USD Acc GBP (LSE:SJPA) has a charge of  0.15%. Other options include the index fund HSBC Japan Index C Acc, with an ongoing charge of just 0.12%, or HSBC MSCI Japan ETF GBP (LSE:HMJP) for 0.19%.

There is also the FTSE Japan index. This is slightly different than the MSCI version. For instance, the FTSE index has around 500 constituents, compared to the MSCI Japan index’s 320. However, the performance of the two indices is closely correlated.

The FTSE Japan index can be tracked via the Vanguard FTSE Japan ETF USD Acc GBP (LSE:VJPB) for an ongoing charge of 0.15%.

Lesser-known is the JPX-Nikkei 400 Index. This index is slightly different in that inclusion depends on several qualitative factors, most notably relating to the corporate governance policies of companies. The idea is that the index has a bias towards stocks that are more shareholder-friendly. The index was created to attract foreign investors concerned about corporate governance in Japan. Changing corporate governance is a key theme in Japanese equities and is discussed in more depth below.

This index can be tracked using the Invesco JPX-Nikkei 400 ETF GBP (LSE:S400). With an ongoing charge of 0.12%, fees are relatively reasonable. Other options include the Xtrackers JPX-Nikkei 400 ETF 1D USD (LSE:XDNY), with an ongoing charge of 0.2%.

The lost decade and Abenomics

Japan’s economy was one of the great success stories of capitalism in the post-war era. At the end of the war, the country’s economy and physical infrastructure lay in tatters. However, thanks to a combination of smart economic policies and a favourable global economic environment, Japan was able to become a manufacturing powerhouse and the world’s second-largest economy by the late 1970s. In the 1980s, however, excitement over Japans economic potential, among other things, led to a bubble in land values and the stock market.

These bubbles began to deflate by the end of 1989, with Japan’s economy entering a period of stagnation in the 1990s. This was known as the “lost decade.” Japan’s stock market has yet to recover from the bubble bursting, with the Nikkei 225 still trading significantly below the level seen at the peak of the bubble at the end of 1989. Japan’s economy also stagnated, although it has still managed to keep its status as a leader in technological innovation.

So, the task of former prime minister Shinzo Abe, after taking power for a second time in 2012, was to turn Japan around. To do this, Abe pursued a series of economic policies known as Abenomics. These policies included more liberal use of fiscal and monetary policy, as well as structural reforms such as increasing employment for women.

Investors around the world responded positively to these reforms, with many viewing Japan as finally turning a corner. Japanese equity performance has been reasonable, with the MSCI Japan returning around 135% between 2012 and 2020 in sterling terms, although it should be noted that was below the return of the MSCI All-Country World Index over the same period in sterling terms.

Corporate governance shake up

One of the big changes that piqued investors interest in the Abe era was an attempt to reform corporate governance. Historically, the managers of Japanese companies have had little accountability to their shareholders and foreign investors were often given even less of a say.

This, understandably, left some investors cautious about investing in Japan. One of Abes flagship reforms was to increase the countrys corporate governance standards.

Managers at Japanese companies often saw little reason to return profits to shareholders through either dividends or share buybacks. Therefore, improved corporate governance is also seen as leading the way for Japanese companies to become more conscious of shareholder remuneration.

As mentioned, one of the key Japanese indices is the JPX-Nikkei 400, which screens for companies with better corporate governance. The index was created, with the encouragement of the Japanese government, to entice foreign investors into investing in the companies that have made corporate governance improvements.

Should Japan be classed as part of the Asia-Pacific region?

Japan is part of the wider Asia-Pacific region alongside other economic powerhouses such as South Korea, China and Taiwan. However, Japanese stocks are often spoken of as stand-alone asset class, in a way that South Korean or Taiwanese stocks almost never are (China is, of course, a different story).

This is because of the sheer size of Japan’s economy and stock market, as well as its unique characteristics. Indeed, it is common to see indices for the region exclude Japan, in the same way that European indices sometimes strip out UK stocks. For example, the MSCI Asia Pacific ex Japan index, or the FTSE Asia Pacific ex Japan.

Without stripping out Japanese equities, these indices end up being dominated by Japan. For instance, Japanese equities form about 34% of the MSCI Asia-Pacific index and about 35% of the FTSE Asia Pacific index.

Investors, therefore, may wish to keep their Japan and broader Asian equity exposure separate. This is generally the approach of Asian-focused active funds, with many fund houses offering Asia-Pacific focused funds without Japan holdings and funds specifically focused on Japan.

The curse of the yen’s safe-haven status

The yen plays a fairly unique role in the world. For several reasons, the country’s currency has come to be seen by global investors as a safe-haven asset. As a result, the currency will often appreciate in value when global markets are worried about something. However, Japan is an export-led economy, so a stronger yen is not exactly welcome. As a result, the Japanese government is sometimes seen as trying to weaken the yen.

Either way, currency fluctuations are important for investors, with a weakening yen acting as a drag on returns. Therefore, many investors opt for currency hedged ETFs when gaining exposure to Japan. The downside of this is that they often have a higher management fee.

Active or passive?

Many UK investors seem to prefer using actively managed funds for their Japan exposure. This is particularly the case when it comes to Japanese small caps. Active managers have had some great success here, with Baillie Gifford Shin Nippon investment trust (LSE:BGS) a shining example.

However, numerous studies have shown that the Japanese market is one of the more efficient in the world, meaning that it is not very easy for active managers to consistently provide outperformance.

Full performance can be found on the company or index summary page on the interactive investor website. Simply click on the company's or index name highlighted in the article.

These articles are provided for information purposes only.  Occasionally, an opinion about whether to buy or sell a specific investment may be provided by third parties.  The content is not intended to be a personal recommendation to buy or sell any financial instrument or product, or to adopt any investment strategy as it is not provided based on an assessment of your investing knowledge and experience, your financial situation or your investment objectives. The value of your investments, and the income derived from them, may go down as well as up. You may not get back all the money that you invest. The investments referred to in this article may not be suitable for all investors, and if in doubt, an investor should seek advice from a qualified investment adviser.

Full performance can be found on the company or index summary page on the interactive investor website. Simply click on the company's or index name highlighted in the article.

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