by Jeff Allan
Foreign investors in the Japanese market have long criticized the Nikkei 225 due to its price-weighted basis. The Nikkei 225’s narrow focus and its tendency to distort perceptions resulted in Japanese retailer Fast Retailing Co. accounting for over 10 percent of the index, while banks only comprise less than 2 percent. Such is the nature of a price-weighted index. On the other side of the token is TOPIX, which is considered the more representative than the Nikkei. Although the TOPIX is capitalization-weighted, the popular consensus is that with nearly 1,700 companies listed on the First Section of the TSE, it is too broad in scope.
Investors had cause to celebrate with the launch of the JPX-Nikkei 400 in January. Jointly calculated by the Japan Exchange Group, the Tokyo Stock Exchange, and the Nikkei, the JPX-Nikkei 400 is a departure from the Nikkei 225 and TOPIX. As reported by the Wall Street Journal, the JPX-Nikkei 400 is weighted by free-float market capitalization, to bring it in line with global standards. It also offers additional screening criteria that are intended to ensure that company composition is appealing to investors.
Focus on Quality
Abenomics has put special emphasis on better return on equity (ROE) by companies. In that vein, it comes as no surprise that the new index puts a heavy importance on the quality of companies that comprise it. The Japan Exchange Group has laid out several quantitative as well as qualitative guidelines that are used to evaluate companies for inclusion on the JPX-Nikkei 400. Notable among the quantitative factors are
Three-year average ROE of at least 40 percent
Three-year cumulative operating profit of at least 40 percent
Market capitalization of at least 20 percent on the base date of selection In a very big nod to foreign investor interests, the qualitative factors go far to address many of the most desirable aspects that fund managers have long sought. These include:
Appointment of Independent Outside Directors ? Japan Exchange awards extra points for companies that have appointed at least two independent outside directors; this will serve to improve corporate governance and increase the shareholder-oriented culture of the companies
International Financial Reporting Standards (IFRS) ? Companies that have adopted or are scheduled to adopt IFRS gain extra points; IFRS acts to unify accounting standards across national borders, making financial information more accessible to international investors
Disclosure of English Earnings Information ? Companies can score additional points by disclosing their earnings information in English via TDNet; a major hurdle many international investors encounter is the Japanese language barrier, which this factor intends to resolve
With this focus on quality, expectations are high for the JPX-Nikkei 400. The Wall Street Journal expects investments to start shifting away from the Nikkei 225 to start tracking the vastly superior JPX-Nikkei 400. Other analysts expect the new index to ultimately replace TOPIX entirely. If recent moves by the Government Pension Investment Fund (GPIF) are any indication, that predication might become reality soon.
In early April, GPIF added the JPX-Nikkei 400 as a benchmark for passive investments. Some analysts see GPIF’s move as the catalyst that will encourage a move from TOPIX to the JPX-Nikkei 400 as the main benchmark.
The Coming of Futures
In mid-April, French bank BNP Paribas conducted the first nine figure options trade on the fledging JPX-Nikkei 400 to a large institutional client. As BNP Paribas found though, the lack of a futures market on the new index meant they had to rely on proxy hedging against any possible market movements.
Hedging challenges have been a primary concern with the young JPX-Nikkei 400. Options to hedge out delta and vega exposure are limited, forcing traders to rely on alternate hedging strategies. Most have opted to avoid more significant risk exposure until futures are available to enable hedging.
Japan Exchange has acknowledged these limitations and also the strong buy-side interest in futures. To that end, the Osaka Securities Exchange (OSE) plans to start offering futures contracts around November of this year, according to a report fromBloomberg news.
The Derivative Benchmark
Many in the market expect that the JPX-Nikkei 400 will become the go-to index for derivatives including ETF, OTC, futures and options products, with the strongest demand expected from institutional investors.
Currently, Nikko and Nomura have launched two ETFs on the new index. As more simple index-linked funds and ETFs help boost liquidity, the next step will be derivatives for the JPX-Nikkei 400. Sources at JP Morgan say that there is already significant interest from institutional investors for these derivatives.
Taken together with the aforementioned GPIF moves, the JPX-Nikkei 400 appears likely to become Japan’s default equity derivative benchmark, displacing the price-weighted Nikkei 225 and the overly broad TOPIX.
The JPX-Nikkei 400 got off to a modest start after initial launch. The lack of futures and hedging options slowed early progress. However, the combination of free-float market capitalization weighting, its focus on quality, and the promise of higher returns has proven extremely attractive to institutional investors.
The JPX-Nikkei 400 has also taken great strides to fulfill several wish list items for international investors. Chief among these are better corporate governance, improved shareholder orientation, and more focus on ROE.
With the introduction of futures and other derivative products later this year, the JPX-Nikkei 400 is poised to become Japan’s index of choice.