Opportunities available for international investors willing to index part of their Japanese equity or fixed income portfolios have been growing over the years with the creation of new indices and new vehicles. But it is Japanese domestic demand that has triggered the recent wave of indexing in Japan.
Indexing has only recently become popular in Japan. The Japanese equity market has been sluggish for the last post-bubble decade, and has not really advocated the use of indexing. Moreover, during this period, a significant number of active managers were able to outperform their benchmarks by staying focused on large capitalisation stocks. On the fixed income front, the downward trend in interest rates attracted investors, but their portfolios remained concentrated in a few liquid government bonds, often staying away from an illiquid corporate sector.
In Japan, interest in indexing has just started to gain momentum, driven by both tactical and strategic trends. On the tactical side, the significant and steady rise of the Japanese stock market has clearly contributed to attracting both international and domestic players to indexed products. At the same time, a more fundamental shift is occurring with the major restructuring of the financial sector and the profound reform of the pension industry. Institutional investors are starting to recognise the merits of indexing in terms of cost efficiency and performance monitoring. Pension funds have started to index a portion of their core assets, as part of the solution to meet their long-term financial objectives. They appear to be following the example of the Pension Fund Association, which recently showed the way by re-allocating its manager selection, with a significant share entrusted to index managers. Finally, as in other parts of the world, even asset management companies are deciding to outsource some of their managed assets to index managers to gain cost efficiencies.
But even though indexing did not come of age until recently in Japan, a proliferation of indices has appeared over the past 15 years, to cover both the Japanese equity and bond markets. These indices can be categorised principally in two groups:
q The global indices, which include Japanese sleeves and are clearly the most popular among non-Japanese investors. They are designed by global providers to be replicable, sometimes at the expense of coverage. They often lack a futures contract;
q The local indices, designed by local data providers or stock exchanges, are broader in coverage and are usually supported by the existence of a futures contract. They are the indices of choice for local market participants, and the benchmarks of choice for Japanese pension funds.
On the fixed income front, the main global indices are the Salomon Smith Barney World Government Bond Index (SSB WGBI) and the JP Morgan Government Bond Index (JPM GBI) series. Both SSB WGBI Japan Index and JPM GBI Japan Index are limited to Japanese government bonds (JGBs) with maturity greater than one year. SSB’s index holds more constituent securities and has a slightly shorter duration, but both indices are close in nature.
As for the local indices, the most popular by far is the Nomura Bond Performance Index (Nomura-BPI), which is the benchmark of choice for all Japanese institutional investors. It has broad coverage, with more than 3,300 issues spread over all sectors of the domestic fixed income market. The allocation breakdown by sector is 64% government, 5% municipal, 7% agency, 9% financial, 14% corporate and 1% Samurai bonds. This index includes a lot of illiquid bonds and is not designed to be replicable.
The Japanese bond market clearly lacks an index with a good balance between coverage and replicability, an index that can address both local specificity and global standards.
On the equity side, the principal global indices until recently have been the Morgan Stanley Capital International (MSCI) Japan Index and the Financial Times Japan index. They are both capitalisation-weighted indices and hold approximately 300 and 430 constituent names, respectively. No futures contract exists, although MSCI is planning to introduce one. The MSCI Japan is the most commonly used benchmark for index funds in the US and continental Europe, the FT Japan having some popularity in the UK. For small capitalisation stocks, the Salomon EMI Japan can be cited.
As for the local indices, the most popular for general publication remains the Nikkei 225, created by the Nihon Keizai Shimbun. Although the price-weighting scheme of the Nikkei 225 is not suitable for replication, this index retains the interest of managers and arbitrageurs because of the very liquid nature of its futures contract traded on the Osaka Stock Exchange (OSE). The Nikkei 300 was later created with a broader universe and a capitalisation-weighted scheme, with the hope of making it the S&P 500 of Japan. But the liquidity of its futures contract remained very low and investors stayed away from it. However, it is worth noting that the only exchange-traded fund in Japan so far is a Nikkei 300 fund. Finally, the broadest local index is the Topix, with more than 1,400 constituent names, capitalisation-weighted. The Topix is by far the benchmark of choice for Japanese pension funds, and a fairly liquid futures contract is traded on the Tokyo Stock Exchange (TSE). The broad coverage of this index is unfortunately tainted by the existence of illiquid small-cap constituents that make it difficult to replicate. A series of Topix sub-indices has been created: the Topix Core 30, the Large 70, the Large100 (Core 30 + Large 70), the Mid 400, the Topix 500 (Large 100 + Mid 400), the Topix Small, and a range of 33 Topix Industry Indices. To complete the picture of local indices we should also mention small capitalisation indices such as the TSE Second Section, the Nikkei OTC Average and the JASDAQ.
A comparison between the MSCI Japan and the Topix can quickly illustrate the gap between global and local indices. The former is the benchmark of choice of non-Japanese institutional investors, while the latter is the favourite of Japanese investors. The MSCI is designed to be replicable but lacks a futures contract. The Topix has much broader coverage and a futures contract, but is not easily replicable. Even if both indices are capitalisation-weighted in nature, their exposure to sectors and factors differs substantially. For instance, the MSCI is more exposed than the Topix to export-oriented companies. As a result, MSCI Japan outperformed Topix by 5% in 1997 with the depreciation of the JPY. However, since October 1998, this trend has reversed with the appreciation of the yen and in 1999, Topix outperform MSCI Japan by more than 12%. Therefore, it is wise to look at the detailed features of the index before choosing it as a benchmark, especially for an indexing strategy where no active decision will ever balance an inherent bias. The gap between global and local indices has generated friction in the trading of large pools of Japanese equities by limiting global crossing opportunities and somewhat segmenting the securities lending market. Securities lending has gained popularity among Japanese pension funds, which use it as a mean to enhance the return of their Topix-indexed assets. This generates additional supply, putting some pressure on already existing off-shore lenders who are dealing with pools of MSCI names, but at the same time creating opportunities for borrowers interested in the Topix names which are not included in the MSCI Japan.
The recent creation of the S&P/Topix 150 jointly by Standard & Poors and the TSE is an attempt to close the gap between local and global indices. This new index is addressing local needs: it provides good tracking with the Topix, and the launch of a futures contract is planned for the fall. At the same time, it is part of the S&P Global 1200, and the construction methodology follows global standards by adjusting for the float.
In terms of vehicles, institutional investors can already gain exposure to most of these indices through index funds, futures, equity swaps, as well as other OTC structures.
We now anticipate the next generation of index vehicles, probably in the form of exchange-traded funds, to provide efficient access to Japanese indices to all investors, through liquid listed products. The Nikkei 300 ETF was not successful probably because it was launched before the Nikkei 300 index itself became widely accepted.
All in all, we can only expect that the creation of new futures contracts, indices and vehicles will continue, in an effort to address clients’ needs and expand further the opportunities for indexing in Japan.
Eric Michel is president and representative director at State Street Global Advisors (Japan) in Tokyo