Japan's stock market at two-decade high: low-cost tracker fund tips

The ‘snap’ election called by Shinzo Abe for October will determine the future of the Japanese economy. A strong result will give him the platform to build on his existing programme of economic stimulus and reforms, widely known as Abenomics, which has been largely supportive of equity valuations in recent years.

-Japan’s stock market hits two-decade high after election - time to buy?

One of the cheapest and most efficient ways to access Japanese equities is through an exchange traded fund (ETF). However, seemingly subtle differences between funds mean that they are not all positioned to benefit in the same way.

Different risk profiles

Specifically, larger Japanese firms have clearly different risk and return characteristics from their mid- and small-cap counterparts. For example, the largest companies in the country are well-known export-oriented multinationals such as Toyota and Sony. These corporate behemoths are primarily affected by shifts in global demand, and have been boosted by currency devaluation in the past five years.

The db x-trackers MSCI Japan (DR) ETF is a good option for investors looking to gain access to the mega- and large-cap segment of the Japanese equity market. Its relatively low fee of 0.3 per cent has contributed to a positive Morningstar rating of Bronze.

However, those looking to capture the performance of the full Japanese market should consider a fund which tracks a broader index. This would include smaller, more domestically focused and less well-known firms that are more sensitive to local economic drivers.

Japanese small caps are tilted towards sectors like real estate, basic materials and industrials. Therefore, strong fiscal spending, including that on infrastructure in the lead up to the Tokyo Olympics in 2020, would likely benefit these smaller players. The Gold-rated iShares Core MSCI Japan IMI ETF tracks 99 per cent of the total market capitalisation in Japan and therefore offers increased exposure to the mid and small caps. Its low fee of 0.2 per cent, coupled with the breadth of offering, has contributed to enviable risk-adjusted performance relative to both its active and its passive peers.

Another strong candidate for a core portfolio building block is the Silver-rated Lyxor Japan Topix (DR) ETF. This fund tracks the sprawling Tokyo Stock Price Index, which covers the entire first section of the Tokyo Stock Exchange and includes an even greater allocation to mid and small caps. Despite our positive view of the index, a relatively high fee of 0.45 per cent a year prevents this fund from receiving our highest level of conviction.

Larger company ETFs

Generally speaking, when evaluating a large cap ETF, we hold a preference for those tracking the broadest indices (i.e. those with the largest number of holdings), as they tend to be more representative of the total market and therefore can be considered a more comprehensive building block. Over the past 15 years, risks and returns have been in line with these theoretical predictions, with the broadest funds beating narrower funds on a risk-adjusted return basis.

Elsewhere, the Bronze-rated Amundi Jpx-Nikkei 400 ETF is a different investment proposition altogether. Uniquely, the index it tracks was launched in 2014 as part of a government initiative to incentivise better corporate governance. It screens its 400 constituents by several profitability and governance factors. This low-cost ‘quality-screened’ fund is most suitable for those hoping to minimise the impact of the governance issues that have plagued Japan for many years.

Finally, another important consideration for UK investors in foreign markets is the potential impact that currency movements can have on returns. This is particularly true when investing in Japanese markets. Those wanting to mitigate the risk of sterling strengthening against the Japanese yen could consider buying a currency-hedged ETF. There are currently a few GBP-hedged variants of funds tracking the Topix, MSCI Japan and Nikkei 400 indices.

Kenneth Lamont is a passive strategies analyst at Morningstar. 

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