The BOJ’s ETF Purchasing Program

The Bank of Japan decided at its July 28–29 meeting to boost its purchases of exchange-traded funds (ETFs) to an annual rate of 6 trillion yen, almost double the previous rate of 3.3 trillion yen. The BOJ began its ETF purchasing in October 2010 at a much more modest annual pace of roughly 450 billion yen. The rate was doubled to 1 trillion yen a year in April 2013 and increased further to around 3 trillion a year in October 2014. As a result of the latest doubling of the BOJ program, BOJ purchases are averaging 2.9% of daily trading values, doubling the previous average.

The ETF purchase program has the apparent objectives of improving market confidence and stimulating consumer and business spending. Its success so far in furthering those objectives has been modest at best. However, equity prices are surely higher than they would have been in the absence of these purchases. In the future, as the BOJ’s ETFs can and probably will be held by the Bank indefinitely, they will likely provide continuing psychological price support for the market.

The BOJ is buying ETFs that track the TOPIX, the Nikkei 225 Stock Average, and the JPX-Nikkei 400. The proportions of the total purchases accounted for by these three indexes have been based on market capitalization: respectively, 54%, 42%, and 4%. In May the BOJ also started buying new ETFs that include companies that are “proactively making investment in physical and human capital.” The plan is to purchase 300 billion yen of such ETFs a year as part of the overall ETF program, but investors have been reluctant thus far to purchase the six new ETFs launched since May 19. Note that the BOJ is limited to holding no more than 50% of any ETF.

The BOJ does not buy individual shares directly. Nor does it buy ETF shares that are on the market. When it places an order for an ETF, the ETF share is newly created by an asset management company, using a basket of shares purchased by a securities company. Thus the BOJ is not limited by the outstanding volume of ETFs in the market.

Views are mixed about what Bloomberg calls “the Bank of Japan’s controversial march to the top of shareholder rankings in the world’s third largest equity market.” Goldman Sachs Investment Research estimates that the BOJ’s current holdings of ETFs are about 70% of the total market cap of ETFs eligible to be purchased and that under the latest expansion of the program, the BOJ’s indirect holdings of TOPIX stocks will reach “3.25% of market cap, or 5.1% adjusted for free float.” Bloomberg estimates that by 2017 the BOJ will be the top shareholder in about a quarter of the Nikkei 225 companies. While so far the BOJ’s purchasing activities do not appear to have affected the market’s smooth functioning, this could change as these activities increase.

Investors welcome the strengthening of share prices likely to result from the increased share purchases. There are some potential negative side effects that are a medium to long-term concern. Goldman Sachs (NYSE:GS) Investment Research notes two concerns that we share. First, the purchases cover broad indexes that include the shares of some companies that do not deserve to have their share prices boosted, companies whose shares may already be overvalued. In other words, the purchases will likely create market distortions that could become significant. The second concern is a likely weakening of corporate governance, which would conflict with the Abe government’s reform efforts to strengthen corporate governance instead. As for shares held in BOJ-owned ETFs, we have doubts that shareholder voting rights will be exercised properly by the asset management companies holding those rights.

Despite these concerns, we remain bullish on the prospects for Japan’s equity markets in the coming months. According to ETF.com, US-based investors can choose from some 30 Japan equity ETFs (aside from inverse or leveraged ETFs). Of these, seven have at least $100 million in assets under management (AUM) and have strong tradability.

The most popular by far, with $14.2 billion AUM, is the iShares MSCI Japan ETF, EWJ, which was launched back in 1996. This ETF is one of the five “total market” ETFs in the top seven and tracks a market-cap index that covers roughly 85% of the investible universe of securities traded in Japan. It excludes the bottom 15% of the market. This ETF is not hedged against currency changes, which has hurt it when the yen has weakened. On the other hand, the lack of a currency hedge has benefited the ETF when the yen has gained against the US dollar, which has been the case thus far this year. The only other unhedged total market ETF in the top seven is the First Trust Japan AlphaDEX (NYSE:FJP). It is quite different from the other index-based ETFs in the top seven, as it uses a quant-based methodology. It is also the most expensive, with an expense ratio of 0.80% compared with 0.48% for EWJ. Over the past six months from the February lows to August 16, the less expensive index-tracking EWJ gained 13.86% on a total return basis, compared with 12.64% for FJP, according to Ned Davis Research.

There are three currency-hedged total market ETFs in the top seven: WisdomTree Japan Hedged Equity (NYSE:DXJ); Deutsche X-trackers MSCI Japan Hedged Equity (NYSE:DBJP); and iShares Currency Hedged MSCI Japan (NYSE:HEWJ). The latter two, both tracking the same cap-weighted MSCI index, have almost identical performance. DXJ, which has the second largest AUM, $7.18 billion, tracks a WisdomTree index that selects export-oriented, dividend-paying Japanese firms and weights them by dividends paid. The export-oriented firms should do relatively well in periods when the yen is weak and underperform when it is strong. The performances of all three funds have been hurt this year by the yen’s advance. HEWJ is off 0.45% over the last six months. DBJP similarly lost 0.44% and DXJ, 1.50%. If the yen should fall after the September BOJ meeting, as the BOJ surely desires, these ETFs would likely return to outperformance.

Finally, among the top seven are two small-cap ETFs. The iShares MSCI Japan Small-Cap (NYSE:SCJ), tracks the cap-weighted MSCI Japan small-cap index. The WisdomTree Japan SmallCap Dividend (NYSE:DFJ), tracks a small-cap index that selects export-oriented dividend-paying firms and weights them by dividends paid. The small-cap sector has been outperforming in Japan this year, as is the case in many markets. SCJ has gained 17.28% over the past six months. DFJ is up 16.08%. Investors that are looking for a Japan small-cap ETF that is hedged against currency fluctuations might consider WisdomTree’s hedged version of its small-cap ETF, DXJS. It has an AUM of $72.09 million and has done slightly better than the hedged total-market ETFs above. It is up 0.83%.

by Cumberland Advisors