How to understand and invest in the Japanese stock market – 3 fund ideas

Japan is the world’s third largest economy and home to one of the largest stock markets in the world. The Tokyo Stock Exchange (TSE) was established in 1878 and is run by the Japan Exchange Group. The TSE is located in the heart of Japan’s capital city, Tokyo, and is made up of almost 3,800 listed companies.

It’s home to some of the best-known companies on the planet, Toyota, Sony and Honda are just a few. There are also lesser-known businesses with the potential to become the household names of tomorrow.

It might be one of the largest stock markets globally, but it can be overlooked or misunderstood by investors. Investors tend to be more familiar with the likes of the London Stock Exchange (LSE) or the New York Stock Exchange (NYSE).

So, what do investors need to know in order to understand the TSE? It’s quite a complex exchange but can be broken down into a number of indices and divisions.

Let’s look at each in more detail.

This isn’t personal advice. If you’re not sure what’s right for your circumstances, ask for financial advice. Remember all investments can fall as well as rise in value, so you could get back less than you invest.

What are the main market divisions?

There are five main divisions within the TSE – the First Section, Second Section, Mothers, JASDAQ (standard and growth) and Tokyo Pro Market.

First and Second Sections

They’re collectively known as the ‘Main Markets’. They represent the larger listed Japanese companies, including some foreign companies too.

The First Section is considered the top-ranking market in terms of company size and liquidity. The Second Section is then made up of the following second tier Japanese companies.

Mothers

Companies with growth potential feature on the Mothers trading market. The aim is that at some point in the future they’ll be reassigned to the First Section.

There’s no restriction on size or business category, but every company needs to have high growth potential, which is determined by the lead market underwriters.

JASDAQ

The JASDAQ is split into two markets, ‘Standard’ and ‘Growth’.

Standard includes growth companies of a certain size and level of performance. Growth includes companies who show even more potential for future growth, usually through unique technologies or business models.

Tokyo Pro Market

The Tokyo Pro Market isn’t a well-known division among day-to-day investors. It was created as a joint venture between the Tokyo Stock Exchange Group and the LSE as a market for professional investors only. They wanted to provide opportunities other markets couldn’t, while also revitalising the financial market in Japan.

What are the main indices?

Some of the main indices include the FTSE Japan, MSCI Japan, TOPIX and one of the most well-known indices, Nikkei 225. Although these are some of the main indices, there are slight variations of each, for example the Nikkei 500.

The FTSE Japan Index represents the performance of large and medium-sized Japanese companies that are constituents of the FTSE All-World Index. It’s a broad index of more than 500 companies including Sony and Nintendo.

The MSCI Japan Index is similar in nature. It’s designed to measure the performance of large and medium-sized Japanese companies, but is only made up of 259 constituents. There’s an overlap of companies featuring on both indices, so their performance is closely linked.

The Tokyo Price Index, more commonly known as TOPIX, is made up of Japanese companies listed in the First Section of the TSE. These companies represent most of Japan’s largest businesses and some believe it’s the most accurate representation of the Japanese economy.

Arguably the most well-known index in Japan is the Nikkei 225, or the Nikkei Stock Average, which is named after a Japanese Economic newspaper. Unlike the TOPIX which is capitalisation weighted and is affected by large market valuations, the Nikkei 225 is price weighted. This means the index is an average of the share prices of all the companies listed.

This means it can be influenced more by highly priced companies, including technology stocks. It’s made up of the largest 225 blue chip companies on the TSE, including Asahi, Nissan and Ricoh.

What are the issues with the current structure?

Historically, Japanese companies haven’t had a great deal of accountability to shareholders and have struggled with governance standards. The TSE is viewed as quite a complex exchange which has made it difficult for companies to meet or understand standards exhibited in other parts of the world.

The Second Section, Mothers and JASDAQ markets overlap one another. They provide very little incentive for listed companies to sustainably grow or continue satisfying the level of quality required after becoming a listed company. Each market division is fairly ambiguous too. That makes them harder to understand and less convenient for lots of investors.

In 2012, Shinzo Abe was elected Prime Minister and one of his aims was to reignite interest in Japanese markets, partly by addressing these complexities. He introduced a series of policies known as Abenomics, which in part aimed to reform corporate governance in Japan.

One example of change was the launch of the JPX Nikkei 400 index in January 2014, which screens for companies with better corporate governance. It was also created to entice foreign investors into investing in companies with strong and improving levels of governance.

Fast forward to today and there are still big changes to come.

TSE Market restructuring and what it means for investors

The TSE is still considered quite complex, and offers few incentives for listed companies to look after shareholders or to grow business sustainably. As a result, the TSE has undergone a major restructuring. It’s Japan’s largest overhaul of equity markets for over a decade.

It aims to raise the standards of listed Japanese companies alongside higher standards to be added to a particular market. Improvements will mean a clearer environmental, social and governance (ESG) focus, including diversity within companies and better disclosure. This could mean companies are viewed more positively, fuelling potential interest from foreign investors.

On 4 April the current market divisions changed into three new market segments – the Prime Market, Standard Market and Growth Market. Investors should be aware that the Tokyo Pro Market has not been included in the restructure and will remain untouched for the time being.

The Prime Market requires listed Japanese companies to have the highest levels of liquidity, corporate governance and commitment to sustainable growth. They also need to demonstrate constructive dialogue with investors.

The Standard and Growth Markets are also required to place an emphasis on liquidity, corporate governance and sustainable growth. But not to same extent of the Prime Market.

Some feel the restructure of the TSE isn’t enough and parts of it fall short compared to the US or European markets. The markets remain complex, the prime market features too many companies and it’s still difficult to uphold the proposed standards of governance. But that doesn’t mean there aren’t opportunities in Japan.

Investment ideas

While Japan is still off the radar for lots of investors, we think the Japanese stock market is attractively valued. There are lots of parts of Japan that are misunderstood and under-researched, so there could be some hidden gems of opportunities for investors.

For those without the time or knowledge to navigate the complexities of investing in Japanese companies for themselves, a fund could be an option.

Tracker funds can be a great way to get diverse and low-cost access to a certain market. They aim to track the performance of a stock market index.

Active funds are another way to invest. They're run by a professional investment manager who will try to beat a certain index, instead of just tracking it. While there’s potential for the fund to perform better than the index over the long run, the reverse is also true.

Investing in funds isn't right for everyone. Investors should only invest if the fund's objectives are aligned with their own, and there's a specific need for the type of investment being made. Investors should understand the specific risks of a fund before they invest, and make sure any new investment forms part of a diversified portfolio.

iShares Japan Equity Index

This fund aims to match the performance of the FTSE Japan – a broad index of more than 500 companies. It invests in every company in the FTSE Japan Index in order to track the index as closely as possible.

While it invests more in larger companies, it can invest in higher-risk smaller companies too. It also invests in a range of different sectors, including industrials, consumer discretionary, technology and healthcare. We think it’s a good option for low-cost, broad exposure to the Japanese stock market.

MORE ABOUT ISHARES JAPAN EQUITY INDEX, INCLUDING CHARGES

ISHARES JAPAN EQUITY INDEX KEY INVESTOR INFORMATION

Man GLG Japan CoreAlpha Equity

The managers invest in large Japanese companies, that mainly feature on the TOPIX. They invest in companies they feel can be bought at a lower price than their true worth, and sell them when they feel the company and the share price has recovered. It’s a style known as value investing. Remember though, not all of these companies are guaranteed to make a recovery.

Their discipline in this approach sets them apart from their peers. The fund invests in a relatively small number of companies. That means each one can have a significant impact on how the fund does, which adds risk.

MORE ABOUT MAN GLG JAPAN COREALPHA EQUITY, INCLUDING CHARGES

MAN GLG JAPAN COREALPHA EQUITY KEY INVESTOR INFORMATION

FSSA Japan Focus

This fund invests in companies that are dominant in their industries, and primarily featured on the TOPIX. The managers believe the strength and quality of the companies they own is what drives returns over the long run.

They tend to invest in relatively few companies which adds risk. Over 70% of the fund is invested in technology, industrials and healthcare companies. This can change over time, depending on where they find what they believe to be the best opportunities.

MORE ABOUT FSSA JAPAN FOCUS, INCLUDING CHARGES

FSSA JAPAN FOCUS KEY INVESTOR INFORMATION

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