The MSCI Japan Index is designed to measure the performance of the large- and mid-cap segments of the Japanese equity market. With 300-325 constituents, the index covers approximately 85% 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. The index is well diversified across industries. At the time of writing, industrials consumer cyclicals, and financial stocks formed the largest sector allocations. On a company level, Toyota is at the top with a weighting of 4%; all remaining constituents are below 3%.
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The fund levies an ongoing charge of 0.30%, a figure that is lower than the median value for MSCI Japan ETFs but higher than other directly comparable passive options. The fund's tracking difference (fund return less index return) has improved since its ongoing charge was cut to 0.30% from 0.50% in April 2017.
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 physical replication of the MSCI Japan Net Total Return Index. This means that the fund holds all the index securities in the same weightings stipulated by the index. The fund uses futures for cash management purposes. This is standard practice and helps limit tracking error.
The fund engages in securities lending to help improve tracking performance. Gross lending revenue is split 70/30 between the fund and Deutsche Bank AG, which also serves as lending agent. Deutsche Bank covers all operational costs associated with the securities-lending transactions.
Over the trailing 12 months to mid-March 2019, fund lent out an average of 11% and a maximum of 38% of its net asset value. This practise has returned 0.05%.
As a general rule, no more than 50% of the fund's assets can be lent out at any given time. Although this activity can help to fully offset holding costs, it exposes investors to an element of counterparty risk. To protect the fund, borrowers are requested to post collateral greater than the loan value. At the time of writing, the collateral basket is predominately composed of high-grade (Aaa - Aa2) euro-denominated government debt and blue-chip European equites and is valued at 106% of fund NAV.
As an additional protection measure, Deutsche Bank provides borrower default indemnification; that is, in the event of a borrower insolvency or default, the bank will indemnify the fund for any shortfall between the proceeds from collateral liquidation and the market value of the securities on loan.
Xtrackers is nearing the end of a transitionary period in which it has made strides towards becoming a standalone asset manager. This process has involved severing links with Deutsche Bank’s investment banking arm, in-housing the management of all its ETFs, and converting a number of products to physical from synthetic replication. The recent rebranding exercise is perhaps the most visible result of this shift. The process, which has been managed smoothly, has required a significant investment in both personnel and infrastructure. Although the management team remains relatively new as a unit, the calibre of recruits has been high, and the systems that have been implemented represent an upgrade on those they have replaced.
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This fund represents a solid option for investors looking to access the Japanese large-cap equity market, but we withhold our highest levels of conviction for low-cost peers that track broader and more representative indexes such as the MSCI Japan IMI and Topix.
The market-cap-weighted MSCI Japan index tracks the performance of around 320 large- and mid-cap Japanese companies, which represent around 85% of the total market value.
Fund performance has been solid if uninspiring, having edged out surviving category peers on a risk-adjusted basis over three, five, and 10 years. The annual tracking difference (fund return less index return) has hovered around the ongoing charge over the past three years. This suggests that the fund has tracked its benchmark tightly (gross of fees).
The fund’s ongoing charge was cut on April 3, 2017, to 0.30% from 0.50%, and benchmark-relative performance has improved since then.
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.
Our conviction surrounding this fund is built around the relatively low-cost, broad, and representative market exposure offered within a market in which passive funds have performed well. That said, broader, more-representative, and cheaper passive options do exist. For these reasons, we have awarded this fund a Morningstar Analyst Rating of Bronze.
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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 exchange-traded fund 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. Uniquely, 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.
Over short periods of time, differences in risk/return profiles may emerge. Investors seeking exposure to domestically focused Japan exposure and smaller companies should favour MSCI Japan IMI or TOPIX over the others.
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There are many 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. Currently, of all the ETFs tracking the MSCI Japan Index, HSBC MSCI Japan ETF has the lowest ongoing charge at 0.19%.
IShares Core MSCI Japan IMI ETF and Vanguard FTSE Japan ETF each also offer broader (1,300 and 500 constituents, respectively) exposure than iShares MSCI Japan ETF for a low fee (ongoing charges of 0.20% and 0.19%, respectively).
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) and Invesco (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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