Why investors can’t afford to ignore the Japanese stock market

Image of graph on electronic device - Dr Samuel Barbos da Cunha

Why investors can’t afford to ignore the Japanese stock market

The third largest economy in the world, Japan is also home to one of the biggest stock markets. Which is why investors from all over the globe shouldn’t ignore the opportunities in Japan, particularly as the world begins to recover from COVID-19.

Japanese equities make up about 7% of the MSCI All-Country World Index. This the largest weighting, save for the US. Furthermore, Japan has an enormously important history of technological innovation and strategic business development and has consistently pioneered the cutting edge. From delivery methods in the late 20th century to automation and AI in 2021, Japan is consistently ahead of the curve.

What is the main stock market index in the Japanese stock market?

The best-known index for the Japanese stock market is the Nikkei 225. This is the index that potential investors will see quoted and discussed in the financial media. It is also used globally as a general indicator of Japan’s economic and stock market health. And, of course, this index tracks Japan’s 225 biggest stocks listed.

However, despite the Nikkei 225’s media weight, UK investors rarely use it to enter the Japanese stock market. Most index funds and exchange traded funds (ETFs) track different indices. This is largely because the Nikkei 225 is not market-capitalisation weighted. Rather, it is price-weighted, which means that the trading prices of the stocks determine how much of the index they take up. It’s common for investors to see this as inferior to market capitalisation, and this is why the Nikkei 225 isn’t tracked by many index funds or ETFs.

Another Japanese index that is at the centre of its market is TOPIX. As this index is weighted by market capitalisation, it is often considered the main metric for Japan’s economic and market performance. UK investors, however, rarely use this index either, when tracking Japan’s market.

Instead, UK investors are more likely to track the MSCI Japan Index, which comprises more than 320 equities. Or they may use the FTSE Japan Index, which has approximately 500 constituents. The performance of both of these is closely linked.

Finally, a lesser talked about index is the JPX-Nikkei 40 Index, which differs from the others in terms of which constituents are included. Different factors are taken into consideration, most importantly corporate governance, and the index generally favours shareholder-friendly stocks. This index was specifically created to attracted overseas investors who are concerned about corporate governance and accountability in Japan. Corporate governance, of course, remains a highly important area of change and an ongoing theme for Japanese equities.

Abenomics and Japan’s economic turnaround

After the second world war, Japan emerged as one of the great capitalist success stories. In 1945, when the war ended, Japan’s very infrastructure as well as its economy were completely decimated. But intelligent economic policies combined with a largely positive global economic outlook led Japan to emerge as manufacturing giant.

By the late 1970s, Japan was one of the world’s leading economies. Just a few years later, however, everything changed. The ongoing optimism regarding Japan’s economic success led to a stock market bubble, among other factors. And, by the end of the 1980s, the bubble was bursting.

Japan entered a decade of economic stagnation during the 1990s, which is now often referred to as the country’s “lost decade”. While the country managed to retain its position as a technological leader and driver of innovation, the stock market became stagnant. By the time former prime minister Shinzo Abe took up his second term in 2012, his aim and focus were firmly on the economic reform of Japan.

His policies became known, in time, as ‘Abenomics’ and included structural reforms such as more employment opportunities for women. Abe also pursued more liberal monetary and fiscal policies. And it worked for investors all around the world, with a general consensus that Japan had finally turned the corner in terms of economic performance.

Shaking up corporate governance in Japan

One of the most fundamental changes that Prime Minister Abe introduced was the start of the reformation of corporate governance. This remains popular with investors who have long disapproved of the secrecy of Japanese companies in terms of their accountability to foreign investors and their shareholders.

Not having any accountability from their investments understandably left investors reticent and suspicious about pursuing opportunities in Japan. By increasing Japan’s standards in this area, Abe changed the whole focus. This is where the JPX-Nikkei 400 (as mentioned earlier) comes in, as it screens companies to ascertain their level of corporate governance.

Turning to Japan’s currency and its place in the world, it’s clear that many global investors view the yen as a safe asset. This means that the value of the yen goes up when global markets are shaken by an external event. As Japan is an economy dictated by exports, this appreciation of its currency isn’t necessarily what’s wanted internally.

For investors, currency fluctuations are always of interest, and a depreciating yen will hold back returns. This is why many investors choose for currency hedged funds when they choose to invest in Japan, although these often come along with higher fees.

While the world’s investors continue to monitor the ongoing impact of the pandemic on the global economy, it’s clear that the Japanese market is consistently efficient and absolutely worth investing in.