The MSCI Japan Investable Market Net Return Index is designed to measure the performance of the Japanese equity market. With around 1,300 constituents, the index covers approximately 99% of the free-float-adjusted market capitalisation in Japan. Components must meet minimum criteria for liquidity, foreign ownership restrictions, and a waiting period for newly listed stocks. The free-float adjustment serves to ensure higher underlying liquidity relative to a pure market-capitalisation weighting. At the time of writing, the biggest exposures were industrials and financials, in line with the average fund in the Morningstar Category. On a company level, Toyota is the largest weighting with 4%; all remaining constituents are below 2%.
The index is reviewed quarterly--in February, May, August, and November. During the May and November semiannual index reviews, the index is rebalanced and the large-, mid-, and small capitalisation cutoff points are recalculated.
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The fund comes with an ongoing charge of 0.20%, which is one of the lowest of any directly comparable funds in the sector. The fund also maintains a sizable cost advantage when compared with active peers. The annual tracking difference (fund return less index return) over recent years suggests that the total holding cost per year approximates the ongoing charge. Other potential costs for the investor include bid-ask spreads and brokerage fees when buy and sell orders are placed for the ETF.
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IShares uses optimised sampling to track the performance of the MSCI Japan IMI Net Return Index. The fund intends to invest in only a subset of the index constituents. The fund uses futures for cash management purposes. This is standard practice and helps limit tracking error.
IShares engages in securities lending and can lend up to 100% of the securities within this fund to improve its performance. The gross revenues generated from this activity are split 62.5%/37.5% between the fund and the lending agent BlackRock, whereby BlackRock covers the costs involved.
The fund lent out 23% on average and a maximum of 38% over the 12 months to the end of December 2018, generating a net 0.05% return for the fund. To protect the fund from borrower's default, BlackRock takes collateral greater than the loan value. Collateral levels vary between 102.5% and 112% of the value of securities on loan, depending on the assets provided by the borrower as collateral. Additional counterparty risk-mitigation measures include borrower default indemnification. Specifically, BlackRock commits to replace the securities that a borrower would fail to return. The indemnification agreement is subject to changes and in some cases without notice.
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This fund is one of the standout offerings in the Japan large-cap Morningstar Category.
The expansive market coverage offered by the MSCI Japan IMI Index means that this exchange-traded fund provides one of the most representative cap-weighted exposures to Japanese large-cap equities.
Covering around 1,300 Japanese companies, including large, mid-, and small caps, the index represents around 99% of the free-float-adjusted market.
With an ongoing charge of just 0.20%, the fund is one of the cheapest in the category. The yawning fee gap between this fund and that charged by the median fund in the category has proved to be a formidable hurdle for active managers.
The low fee, coupled with an underperformance of active managers, has seen the fund comfortably outperform surviving Morningstar Category peers over three and five years on a risk-adjusted basis.
Furthermore, the MSCI Japan IMI Index has also outpaced the narrower, more popular MSCI Japan Index over the same period on a risk-adjusted basis.
Investors in all foreign markets should be aware of the potential impact that currency movements can have on returns. For example, a UK investor in the Japanese equity markets is exposed to both the returns on the underlying market and the fluctuations in the pound/yen exchange rate. Over long periods, the impact of exchange-rate fluctuations is likely to be a wash, consistent with the historical pattern.
IShares has a seasoned passive management team befitting the dominant ETF provider in Europe. The team can leverage market-leading technology and a well-oiled securities-lending program while managing its funds.
Our strong conviction on the merits of this fund is built around the very broad and representative market exposure offered, its low fee structure, superior performance versus passive peers, and evidence that active managers struggle to add value within the Japanese large-cap Morningstar Category. For these reasons, this fund has been awarded a Morningstar Analyst Rating of Gold.
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Passive investors in broad Japanese equities have an eclectic box of indexes from which to select their preferred tool. Even among cap-weighted funds, there is a range of different-sized options to consider.
Of these, the most tracked index by ETFs in Europe is the MSCI Japan. With around 320 constituents, this index captures approximately 85% of the free-float-adjusted market capitalisation and is designed to measure the performance of the large- and mid-cap segments of the Japanese equity market.
Broader in terms of size, with almost 500 constituents, is the cap-weighted FTSE Japan Index, which also attempts to capture the performance of large caps and mid-caps. With the Japan Investable Market Index (IMI), MSCI expands coverage to include small caps with around 1,300 holdings, which represent 99% of the free-float-adjusted market capitalisation in Japan.
Rounding out the cap-weighted options is the sprawling Tokyo Stock Price Index (TOPIX), which approximates total market coverage with close to 2,100 constituents. Elsewhere, the JPX Nikkei 225 Index weights constituents by stock price rather than by market capitalisation. This approach to indexing has largely fallen out of favour, partly because firms find themselves directly in control of their own weighting in the index. Also, being one of the narrowest major Japanese equity indexes available, the Nikkei 225 is also the most concentrated.
Not to be confused with its cousin the Nikkei 225, the JPX Nikkei 400 is a different investment proposition altogether. It was launched in early 2014 as part of a government initiative to give incentive to better corporate governance. It screens its 400 constituents by several factors, including return on equity, operating profit, and corporate governance credentials. The selected stocks are then weighted by their market capitalisation, with a 1.5% cap applied on individual names. The result largely resembles an unscreened cap-weighted index.
Over the trailing 15-year period (to March 2019), index Sharpe ratios have fallen in line with theoretical predictions. The TOPIX has been the top performer over the period. It is followed by the MSCI Japan IMI, FTSE Japan, and MSCI Japan, each of which have progressively lower risk-adjusted returns than the last over the same periods.
However, over shorter periods of time, differences in risk and return profiles may emerge. Investors seeking exposure to domestically focused Japan exposure and smaller companies should favour MSCI Japan IMI or TOPIX over the other indexes.
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There are many other options to gain exposure to the Japanese equity market. The range of available funds enables investors to invest via a variety of standard market-cap as well as strategic-beta indexes. Vanguard FTSE Japan ETF offers comparable exposure to iShares Core Japan IMI ETF for an equally low fee. Because of the cap-weighting methodology employed by both strategies, the difference between Vanguard's 500 and iShares' 1,300 constituents is not as dramatic as it may seem. This is because each additional constituent is smaller than the last as we move down the cap spectrum and has a decreasing impact on the percentage of total market covered. The MSCI Japan Index, which, with around 320 stocks, covers 85% of the market, is the most commonly tracked Japanese equity index. The physically replicated HSBC MSCI Japan offers the lowest cost ETF with an ongoing charge of 0.19%.
Another popular alternative to access the Japanese equity market is the Nikkei 400 Index. It uses qualitative and quantitative scoring to select 400 companies that meet specific quality requirements and have an investor-focused management approach. Currently, Amundi (ongoing charge of 0.18%) and Invesco (ongoing charge of 0.20%) offer the cheapest Nikkei 400 products. Finally, the broadest market exposure to Japanese equity is provided by funds tracking the TOPIX, which is made up of around 2,100 constituents. Amundi Japan Topix ETF currently has the lowest ongoing charge of 0.20%.
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