Japan Etf Investment: A Guide To Getting Started

After decades of stagnation, Japan is rising again as a place to invest. The easiest way to invest in the whole Japanese stock market is to invest in a broad market index, which can be done at low cost by using ETFs. There are 7 indices available on the Japanese stock market which are tracked by 27 ETFs. The Nikkei 225 Stock Average, Japan's primary stock index, includes the top 225 blue-chip companies listed on the Tokyo Stock Exchange. Although international traders cannot invest directly in the index, you can gain exposure to the underlying stocks within the Nikkei 225 via an exchange-traded fund (ETF). This is the simplest way to invest in Japanese stocks.

Currency-hedged ETFs

When investing in foreign companies, you are not only betting on the success of the asset but also making a wager on the fluctuations of the foreign currency market. Currency-hedged ETFs protect investors from these exchange rate movements by holding currency-forward contracts. These contracts lock in a predetermined future exchange rate, eliminating the uncertainty of exchange rate movements and providing a payout if the exchange rate moves against the investor. This is particularly beneficial if the local currency is expected to depreciate relative to the investor's home currency.

For example, the iShares MSCI Japan ETF (EWJ) is a currency-hedged ETF that returned 48.37% as of March 31, 2024, while its unhedged counterpart only returned 24.31%. This outperformance can be attributed to the depreciation of the yen against the US dollar during the same period.

There are two main types of currency-hedged ETFs: single-currency and multiple-currency. Single-currency-hedged ETFs, such as the iShares MSCI Japan ETF, are more common and focus on a specific foreign currency. Multiple-currency-hedging ETFs, on the other hand, may focus on a particular region or company size and hold a basket of foreign stocks or bonds as their underlying investment.

While currency-hedged ETFs can provide benefits such as reduced risk and improved returns in certain scenarios, it's important to consider the potential drawbacks. These ETFs often have higher management fees and transaction costs associated with executing the hedging strategy. Additionally, the process of refreshing the currency-forward contracts at the end of each month may expose investors to capital gains distributions when the contracts are profitable.

Overall, currency-hedged ETFs can be a reasonable investment option for those looking to reduce the risk associated with exchange rate fluctuations when investing in international markets. However, it's important to carefully consider the potential benefits and drawbacks before investing.

Japan's economic growth

Japan's economy is the fourth-largest in the world by nominal GDP and the fifth-largest by purchasing power parity (PPP). It constituted 4.2% of the world's economy on a nominal basis in 2022. The country's per capita GDP (PPP) was at $54,184 in 2024.

Japan's economy is highly service-dominated, contributing approximately 70% of GDP, with the remainder coming from the industrial sector, particularly automobile manufacturing. Japan is the third-biggest producer of automobiles in the world, with Toyota being the largest manufacturer of cars globally.

After decades of stagnation, Japan's economy is showing signs of a comeback. Its GDP rebounded by 0.7% in the second quarter of 2024, thanks to strong domestic demand. Consumer spending grew 0.9% from the previous quarter, and residential and non-residential private investments picked up. Wage gains and a growing yen are driving households' spending power and domestic demand.

However, persistent inflation remains a challenge for Japan's economic growth. Headline inflation was up 3% in August 2024 compared to the previous year, with the costs of fresh food and energy particularly high. The Bank of Japan has kept interest rates steady but has signaled a willingness to eventually raise them to 1%.

Japan's economy is also facing challenges due to its aging and declining population, which has fallen from 128.5 million people in 2010 to 122.6 million in 2024. The working-age population consisted of approximately 59.4% of the total population in 2022, the lowest rate among all OECD countries.

Despite these challenges, Japan remains an attractive destination for investors. Its stocks are well-priced, and the country benefits from political tensions between the US and China, making it a more attractive source of corporate investments. Japan's GDP is rising at 1.6% annually, ending years of deflation.

• Japan's economy is the fourth-largest in the world by nominal GDP and fifth-largest by PPP.
• The service sector dominates, contributing about 70% of GDP, with the industrial sector, particularly automobile manufacturing, making up most of the rest.
• Japan's economy is showing signs of recovery, with a 0.7% rebound in the second quarter of 2024 driven by strong domestic demand and consumer spending.
• Wage gains and a stronger yen are boosting households' spending power.
• Inflation is a persistent challenge, with headline inflation at 3% in August 2024.
• The Bank of Japan has maintained low-interest rates but indicated a potential future increase to 1%.
• Japan's population is aging and declining, falling from 128.5 million in 2010 to 122.6 million in 2024, with a low working-age population rate.
• Japan remains an attractive investment destination due to well-priced stocks and its position as a source of corporate investments.

Political environment

Japan is a constitutional monarchy with a parliamentary regime. The Emperor is the head of state, and the role is largely ceremonial. The Prime Minister is the Head of the Government and enjoys executive powers, including the implementation of the law and the running of day-to-day affairs. The Cabinet is appointed by the Prime Minister. The current Prime Minister is Fumio Kishida, who has held the position since October 2021.

The legislature in Japan is bicameral. The parliament, called the National Diet, consists of the House of Councillors (the upper house) and the House of Representatives (the lower house). The House of Councillors contains 248 members, elected through a popular vote for six-year terms, with half of the membership being renewed every three years. The House of Representatives contains 465 members, elected through a popular vote for four-year terms.

The current ruling coalition, comprised of the Liberal Democratic Party (LDP) and Komeito, commands a majority in both the House of Representatives, holding 63% of the seats, and in the House of Councillors, with 58% representation. However, support for Fumio Kishida's government has sharply declined to below 30% amidst controversies surrounding the LDP's connections to the Unification Church and a series of ministerial scandals.

The Japanese government is concerned about regional security imbalances, particularly regarding China’s growing assertiveness. Japan identified the situation surrounding Taiwan as a national security threat, with some representatives of the LDP stating that a "major incident" over Taiwan would trigger the deployment of the Self-Defense Forces (SDF). Against this backdrop of escalating geopolitical tensions, Japan has shifted its focus towards enhancing supply-chain resilience and energy security.

Diplomatic relations with South Korea have been improving, with Korean President Yoon proclaiming that South Korea and Japan “share universal values” and common interests. Japan is also a member of several international economic organisations, including the G7, G20, and IMF, and has signed numerous free trade agreements, such as the Regional Comprehensive Economic Partnership (RCEP).

Japan's economy is the third-largest in the world and is heavily reliant on exports, making it vulnerable to external impacts and global economic slowdowns. The country has the highest debt-to-GDP ratio globally, estimated at 260.1% in 2022, and faces challenges such as high inflation, subdued global demand, and demographic issues like an ageing society and declining birth rate. However, Japan's industrial sector is diverse and innovative, with strengths in automotive, electronics, and machinery. The service sector, including finance, insurance, and real estate, dominates the economy and reflects Japan's status as a global financial hub.

Labour reforms

Overtime Hours

The new laws cap the maximum amount of overtime employees can be required to perform. This is set at 100 hours in any one month, 80 hours or more averaged over a two to six-month reference period, or 720 hours a year. Criminal penalties will be imposed on employers who breach these rules. This cap came into effect on 1 April 2019 for large employers and a year later for small and medium-sized companies.

Overtime Premium Rule

From 1 April 2023, all employers will have to pay a 150% premium to employees who work more than 60 hours of overtime in a month.

Working Time

From 1 April 2019, employers are legally required to record employees' working hours.

Minimum Daily Rest Period

Employers are encouraged to set a minimum daily rest period from 1 April 2019.

Exemption from Overtime

From 1 April 2019, employers are exempt from paying overtime premiums to certain specialists who work during their vacation or perform overtime or night work (defined as working between 10 pm and 5 am). This exemption requires the agreement of a labour-management committee, which must also agree on health-related measures for these employees, including rest periods, health checks and holiday entitlement.

Monitoring of Statutory Paid Time Off

From 1 April 2019, employers must monitor employees' use of paid annual leave and designate five days of leave for employees with at least 10 days of unused annual leave. Employers may face penalties of up to JPY 300,000 for non-compliance.

Increased Authority for Company Physicians

From 1 April 2019, company-appointed physicians have more authority over employees' health.

Flex-time Procedures for Calculating Overtime

From 1 April 2019, the reference period for calculating aggregated working and overtime hours increased to three months, up from one month, subject to certain criteria.

Alternative Dispute Resolution (ADR)

From 1 April 2020, fixed-term employees and dispatched workers at large companies gained the right to use ADR to enforce equal treatment provisions. This measure was extended to small and medium-sized companies from 1 April 2021.

Working Conditions

From 1 April 2020 (for large companies) and 1 April 2021 (for small and medium-sized companies), the following changes were implemented to reduce the differences in working conditions between regular and non-regular workers:

• Unreasonable differences in working conditions (including base salary, bonus payments and other allowances) for permanent regular employees, fixed-term and irregular employees are prohibited.
• Regular and irregular employees can ask employers to explain differences in their working conditions.
• Dispatched (or temporary) workers can ask employers to explain how the terms and conditions of their work differ from those of employees doing comparable work.

Choosing active or passive funds

When investing in ETFs, you can choose between active or passive funds. Here are some things to consider when making your choice:

Active funds

Active funds are managed by a fund manager who makes investment decisions on your behalf. They will decide which stocks, bonds, or other investments to buy or sell within the fund. Active funds usually have higher fees because you are paying for the expertise of the fund manager. Active funds can be a good option if you don't have the time or expertise to manage your investments yourself. They can also be a good choice if you are looking for a more personalised investment strategy.

Passive funds

Passive funds, on the other hand, simply track a particular market index, such as the S&P 500 or the MSCI World Index. They aim to replicate the performance of that index, rather than trying to outperform it. Passive funds tend to have lower fees than active funds because they are not actively managed. They can be a good option if you want a more hands-off approach to investing and are happy with market-level returns. Passive funds are also a good choice if you want to keep costs low, as higher fees can eat into your investment returns over time.

Things to consider

When choosing between active and passive funds, it's important to consider your investment goals, risk tolerance, and fees. Active funds may offer the potential for higher returns, but they also come with higher fees and the risk that the fund manager's strategy may not pay off. Passive funds, on the other hand, offer more predictable returns and lower fees, but may not perform as well as actively managed funds in certain market conditions. It's also worth noting that, while Japan ETFs can be a good way to gain exposure to the Japanese market, they are also subject to currency risk, as the value of the Japanese yen can fluctuate against other currencies.

Active funds:

• WisdomTree Japan Hedged Equity Fund: This ETF aims to reduce currency risk by hedging against fluctuations in the value of the Japanese yen. It has returned 19.5% this year, including dividends.
• Goldman Sachs ActiveBeta Japan Equity ETF: This ETF uses a rules-based approach to selecting investments, blending active and passive investing strategies.

Passive funds:

• IShares MSCI Japan ETF: This ETF tracks the MSCI Japan Index and is the oldest and largest Japan ETF in terms of assets under management. It has an expense ratio of 0.50% and a 12-month return of 20.8%.
• Vanguard FTSE Japan UCITS ETF: This ETF tracks the FTSE Japan index and has a TER of 0.15%. It has returned 16.7% and 5.9% over the past one and three years, respectively.

Frequently asked questions