The Bank Of Japan And Smart Beta

Today’s news has the Bank of Japan buying more ETFs. Should you care?

Today’s news has the Bank of Japan buying more ETFs. Should you care?

Sometimes everything old is new again. Today there’s a headline running around that the Bank of Japan is going to be buying up more ETFs in its effort to buy essentially anything it can to keep asset prices up and the economy moving. The coverage over at ZeroHedge summed it up nicely:

“The BOJ’s ETF expansion is nothing new and had been telegraphed before. Recall from April, when we learned that Japan’s central bank will probably double purchases of exchange-traded funds in a second round of monetary easing under Governor Haruhiko Kuroda anticipated in coming months. The Bank of Japan ... will increase annual ETF buys to 2 trillion yen [$19.6 billion] in months ahead, according to a survey of 36 analysts.”

But for many investors, the interesting headline here might be that the discussion is around the JPX-Nikkei Index 400. First a bit of context on the Japanese ETF market itself: It’s relatively small—under $100 billion in AUM—and the largest funds in the equity space track, as you might expect, boring old traditional indexes. The Nikkei 225 is a price-weighted mega-cap index, similar to (and in some ways, as ridiculous as) the Dow here in the U.S. The TOPIX, with 1,300 market-cap-weighted stocks, is roughly equivalent to something like the Russell 1000 or the S&P 500 here in the U.S.

Index development in Japan had been relatively static for years, until the Nikkei announced last year it was launching the Nikkei 400. Rather than just taking a me-too approach, the Nikkei 400 would probably pass most investors’ smell test as “smart beta” in its approach. Specifically, it:

• Screens out companies with bad balance sheets, bad income statements and those under three years old
• Weights the remaining securities based on return on equity, profit and market cap, and several measurements of corporate governance and investor-friendliness like transparency.

To my mind, this is a bit like a mashup of a fundamental strategy backed with a pro-capitalism ESG screen. So how’s it done? Well, the first ETF in Japan tracking the strategy just launched at the beginning of the year, but since then, it’s done quite well, beating both of the “old guard” indexes quite handily.

Source: Bloomberg

So, the fact that the Bank of Japan is interested makes some sense. But how real is it? Initial commentary has been that until the ETFs tracking the index really take off, there’s no way the BOJ could be a buyer. After all, the theory goes, the largest ETF, from MAXIS, has just 31 billion yen ($380 million or so), and trades just a few thousand shares a day.

And that’s the first place things are wrong. If the BOJ wanted to start putting 2 trillion yen all at once into even that specific ETF, it absolutely could. It just wouldn’t be dumb enough to do it on the open market. It would work with an AP to roll up a basket.

And because the weighting scheme of the Nikkei 400 takes market cap into account, the smallest companies are barely represented. The smallest, Kinugawa Rubber Industrial, receives just 6/10ths of a basis point of allocation. Even if all 2 trillion hit the index, that would still be just 120 million yen ($1.2 million) headed Kinugawa’s way. While Kinugawa’s small, even that enormous allocation would only be a fraction of a day’s volume.

That’s the beauty of the ETF structure—it can absorb infinite flows right until it starts impacting the underlying.

As a U.S. investor, does any of this matter? The Bank of Japan has been buying ETFs for well over a year now, so it’s important to recognize that this is not news. The Bank of Japan has on its balance sheet 2.9 trillion yen of index-linked ETF assets already (roughly $30 billion—a significant portion of the ETF market).

While that ownership of $30 billion in equities has certainly helped keep your shares in, say, the db X-trackers MSCI Japan Hedged Equity ETF (DBJP | B-67) up, it’s truly a drop in the bucket when you consider the overall equity market in Japan is worth something on the order of $5 trillion.

Is more buying supportive of asset prices? Sure. But I wouldn’t be rushing out to load up on equities over it.

And the BOJ’s hat tip to smart beta? As a U.S. investor there is no ETF listed in the U.S. that tracks the Nikkei 400, nor is there even a fund in registration. What about buying a Japan-listed Nikkei 400 ETF? Good luck with that.

At the time this article was written, the author held no positions in the security mentioned. Contact Dave Nadig at [email protected].