The FTSE Japan Net Return Index is a free-float-adjusted, market-cap-weighted index that offers exposure to around 500 of the largest Japanese stocks. The index is composed of large- and mid-cap Japanese companies that are constituents of the FTSE All-World Index. The constituents of the index are reviewed semiannually in March and September. The fund is well diversified on a sector and stock level.
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The fund comes with an ongoing charge of 0.19%, making it one of the lowest-cost passive funds in the category. The fund also maintains a considerable cost advantage when compared with active peers.
The annual tracking difference (fund return less index return) suggests that the total holding cost per year approximates the ongoing charge, indicating strong tracking performance.
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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The fund uses full replication to track the performance of the FTSE Japan Net Return Index. The fund buys all the securities in the same weightings stipulated by the index. Dividends received from the stocks are invested in futures until they are distributed to fundholders on a quarterly basis. This dividend treatment helps to minimise tracking error.
Vanguard also engages in securities lending for this fund, a practice that began in November 2016. In the 12 months to the end of December 2018, the fund lent a maximum of 1% of fund assets, returning 0.01% to the fund.
The firm’s securities lending revenue split of 90/10 in favour of the fund is highly favourable to the end investor. Counterparty risk is mitigated by requiring high quality collateral (including US Treasuries, UK Gilts, German Bunds, French OATs, and Dutch Sovereign Debt securities) in excess of the value of the stocks lent out. The percentage of assets that can be lent out by any ETF is capped at 7.5% of NAV.
Vanguard still is a small player in the European ETF marketplace, but the company is one of the largest money managers globally. Vanguard is well known for giving investors a fair deal across the board. This corporate ethos is borne out of its mutual ownership structure. From Vanguard, investors can mostly expect straightforward products and low costs. By the same token, this probably precludes it from offering investors the widest of choices.
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The Vanguard FTSE Japan ETF is one of the very best trackers in a category in which passive funds have performed well.
The fund offers broad and representative cap-weighted exposure to Japanese large-cap equities. With around 500 constituents, including a number of mid-caps and small caps, the FTSE Japan Index stands as a better proposition than the more popular but narrower MSCI Japan Index.
With an ongoing charge of only 0.19%, the fund is one of the cheapest in the Japan large-cap Morningstar Category.
The yawning fee gap between this fund and that charged by the average fund in the category has proved to be a formidable hurdle for active managers.
The low fee has helped the fund outshine its surviving category peers over three and five years when ranked on a risk-adjusted basis. This strong performance can be extended out to 10 and 15 years if we include the returns of older funds tracking the same index.
The fund has hugged its index closely since inception, trailing by an amount close to its ongoing charge.
We have a favourable view of Vanguard’s distinctive mutual ownership structure, which means it is compelled to operate at cost and put investors’ interests first. The indexing team is well-resourced and dotted with industry veterans.
Investors in all foreign markets should be aware of the potential impact that currency movements can have on returns.
This is particularly true when investing in Japanese markets. 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.
Our strong conviction surrounding this fund is built around the 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, 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, 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.
We hold a general preference for broader cap-weighted indexes as they tend to be more representative of the total market and therefore a more comprehensive building block. The broader the index, the harder it becomes for active managers to boost relative returns over the long term through stock selection.
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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As of writing, no other exchange-traded funds track the FTSE Japan Index. 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.
The iShares Core Japan IMI ETF offers similar exposure to the Vanguard FTSE Japan ETF for an equally low fee. Because of the cap-weighting methodology employed by both these strategies, the difference between the Vanguard’s 500 and the 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, which, with around 320 stocks, covers 85% of the market, is the most commonly tracked Japanese equity index. The physically replicated HSBC Japan has the lowest ongoing charge of all ETFs tracking this index. Another popular alternative to gain access to 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 (0.18% ongoing charge) offers the cheapest Nikkei 400 product.
Finally, the broadest market exposure to Japanese equity is provided by funds tracking the Tokyo Stock Price Index (TOPIX), which is made up of around 2,100 constituents. The Amundi Japan Topix ETF currently has the lowest ongoing charge of 0.20%.
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