Masaryk University Faculty of Economics and Administration

Field of study: Finance

ANALYSIS OF THE JAPANESE INDICES Analýza japonských indexů Bachelor thesis

Thesis supervisor: Author: doc. Ing. Martin SVOBODA, Ph.D. Sabina BINZARU

Brno, 2014

Author’s name and surname: Sabina Binzaru

Name of bachelor thesis: Analysis of the Japanese indices

Department: Finance

Bachelor thesis supervisor: doc. Ing. Martin SVOBODA, Ph.D.

Year of defense: 2014

Annotation This bachelor thesis focuses on the Japanese stock indices, particularly on Nikkei 225 and TOPIX. The main goal of the thesis is to analyze the main characteristics of the previously mentioned indices, evaluate and compare their way of construction, regard the possibility of index investing and formulate recommendations on this issue. The thesis consists of four chapters; the first chapter makes an introduction to indices mentioning their history, fundamental uses and factors of relevance. The second chapter focuses on index construction taking into account weighting, calculation and adjustment methods. The third chapter briefly introduces Japanese stock indices and then analyzes and compares the chosen Japanese indices from different perspectives. The last chapter is aiming at describing index investment opportunities and risks and discovering and comparing index investing products that have Nikkei 225 and TOPIX as underlying.

Anotace Tato bakalářská práce se zaměřuje na japonských akciových indexů, zejména na Nikkei 225 a TOPIX. Hlavním cílem práce je analyzovat základní charakteristiky výše uvedených indexů, hodnotit a porovnávat jejich způsob konstrukce, možnost investování do indexů a formulovat doporučení týkající se této problematiky. Práce se skládá ze čtyř kapitol; první kapitola je úvodem do indexů zmiňující jejich historii, základní použití a faktory které ovlivňují vypovídací schopnost indexu. Druhá kapitola se zaměřuje na konstrukce indexů berouce v úvahu způsob vážení a metody kalkulace a úpravy. Třetí kapitola stručně představí japonské akciové indexy a následně analyzuje a srovnává vybrané japonské indexy z různých pohledů. Poslední kapitola je zaměřená na popis investiční příležitosti a rizika investování do indexů a zjištění a srovnání investičních produktů, které mají Nikkei 225 a TOPIX jako podkladové aktivum.

Keywords Index investing, Nikkei 225, TOPIX, Free-Float Value, Tokyo Stock Exchange

Klíčová slova Indexové investování, Nikkei 225, TOPIX, Free-Float Value, Tokyo Stock Exchange

Declaration

I declare that I have been working on the thesis Analysis of the Japanese Indices individually under the supervision of doc. Ing. Martin Svoboda, Ph.D. and I have mentioned all the literary and other specialized sources in compliance with the legal regulations, internal regulation of Masaryk University and internal proceedings of Masaryk University and of the Faculty of Economics and Administration MU.

Brno, April 10, 2014

………………………………… Author’s signature

Acknowledgements

I would like to express my gratitude to doc. Ing. Martin SVOBODA, Ph.D. for all the time devoted to my thesis, for his valuable advice that has helped me to develop this work and for all the things taught during the Financial Markets course. I would also like to thank my Japanese teacher, Kohshi Hirayama for helping me to better understand the geopolitical and financial situation of Japan in the last centuries.

Contents Introduction 8

Chapter 1 General index characteristics 9 1.1 Definition and short history 9 1.2 Fundamental uses of indices 10 1.3 Factors of relevance 11

Chapter 2 Index construction 12 2.1 Key criteria for an effective index 12 2.2 Index weighting methods 13 2.3 Index construction guidelines 14 2.4 Index adjustment 16 2.5 Free-Float Weight 17

Chapter 3 Japanese stock indices 18 3.1 Japanese stock indices 18 3.2 Nikkei Stock Average 19 3.3 TOPIX 21 3.4 Japanese indices comparison 24 3.5 The joint index JPX-Nikkei Index 400 28

Chapter 4 Index investing 30 4.1 Index investing – active vs. passive 30 4.2 Factors contributing to the growth of indexing 31 4.3 Index investment opportunities 32 4.3.1 Index funds 33 4.3.2 Index certificates 35 4.3.3 Index products 36 4.3.3.1 Exchange-traded funds 36 4.3.3.2 Index derivatives 37 4.3.3.3 Choosing among index products 39 4.4 Nikkei 225 and TOPIX investing 40 4.5 Index investing comparison 42

Conclusion 45 References 46 List of graphs 49 List of tables 49 List of pictures 49 List of annexes 50

Introduction

Being a significant, powerful equity market in the world, Japan has always deserved attention from local and international investors. As following the evolution of each security is a long and intricate process, there are stock indices that help investors understand the economic situation of Japan. There are two major indices that are calculated in this country – Nikkei 225 and TOPIX, both of them being followed on international scale.

The main goal of this thesis is to focus on the analysis of the Japanese stock indices evaluating their method of construction and providing recommendation on index investing. As these two indices are constantly competing for superiority, I have decided to research this aspect and to present arguments why a certain index is better than the other and in which cases. Besides studying their method of construction, I have also compared several financial instruments having those indices as underlying.

The first chapter is dedicated to the overall characteristics of a stock index, mentioning its definition and brief history, its fundamental uses and the factors that make it relevant. The second chapter is focusing on index construction, high lightening the key criteria for an effective index, possible methods of weighting a stock, some essential guidelines for building an index, the techniques of adjusting it due to changes on the stock market and the concept of Free-Float Weight.

The third chapter represents the core of the practical part of this thesis. It begins by briefly introducing the indices calculated on Japanese stock market in Japan and overseas. It follows with the detailed analysis of Nikkei 225 and TOPIX index construction according to general criteria like structure, constituents’ changes, calculation method, evolution, etc. In the next subchapter a complex comparison of these two indices will be developed, regarding their performance, usage, composition, sector weight, calculation and adjustment methodology. Lastly, I have included information about a new joint index calculated in Japan, which represents a very interesting combination of different features of those two indices.

The last chapter concentrates on index investing possibilities and provides examples of ways to invest in Nikkei 225 and TOPIX. A description of index investing strategy, the factors that have contributed to the growth of indexing worldwide, an array of index investing opportunities and finally, a practical comparison between index certificates and ETFs on these two indices will get us closer to the main aim. In order to fulfill it, I have used the following methods: analysis, synthesis and comparison.

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Chapter 1 General index characteristics

1.1 Definition and short history The very used on the financial markets term of index can be defined as following: “an agregate indicator, which informs about the overall evolution and situation on the market (market index) or in a certain sector (sector index)“.1 Grace to the fact that an index concentrates in one number the evolution of a certain range of securities it serves as an indicator of the whole market.

The idea of creating an indicator that would inform about the market situation was born in the United States in the nineteenth century. In 1884, Charles Dow, the founder of Wall Street Journal, together with Edward Davis Jones have published for the first time the Dow Jones Average Index. This index included 11 companies operating in the railroad sector which were given weight in the index according to their share price. Their main aim was to provide investors through an indicator a general overview of the market situation. A few years later, in 1896, Dow Jones decided to separate the railroad stocks in a special index (Transportation Index) and to create a new industrial average index based on 12 stocks. The publication of Dow Jones Industrial Average began on May 26, 1986. Nowadays, it comprises 30 stocks and remains one of the few price weighted indices.2

A revolutionary year in index history was 1923, when for the first time Standard Security Corporation (now Standard & Poor’s) has created the first index based on market capitalization weighting. Even if at the beginning it included only 90 securities, it expanded over years reaching a value of 500 securities in 1957. Grace to its complexity, it was regarded as the index that best represents the U.S. equity market. That is why both the first retail index fund created in 1976 by Vanguard and the first exchange-traded fund established in 1993 by State Street Global Investors have selected it as their benchmark.3

Since then, the world of indices has considerably evolved. New techniques for index calculation and adjustment appeared, and what is more important, a vast range of index-based products have seen the light. There are several types of indices if we speak about the securities incorporated in it, so that we have stock indices, bond indices, commodity indices, etc. However, the most frequently used and important are stock indices, on which I am going to focus my attention in this thesis.

1 VESELA, Jitka. Investování na kapitálových trzích. Prague: ASPI, 2007. 704 p. ISBN 978-80-7357-297-6, p. 75. 2 SCHOENFELD A., Steven. Active Index investing, maximizing portfolio performance and minimizing risk through global index strategies. Hoboken, New Jersey: John Wiley and Sons, Inc., 2004. 688 p. ISBN 0-471-25707-9, p. 14. 3 FERRI A., Richard. The power of passive investing: more wealth with less work. Hoboken, New Jersey: John Wiley and Sons, Inc., 2011. 264 p. ISBN 978-0-470-59220-5, p. 10. 9

1.2 Fundamental uses of indices Stock indices are calculated all over the world and represent different possible markets such as countries, regions, assets classes, etc. Indices became primordial in the investment industry and their usage is appreciable. In his book Active Index Investing, Schoenfeld defines four major key uses of indices, which are: a) Gauge of public or market sentiment From the moment of their creation, indices have been primarly used to define the overall situation of a market in a certain moment. The users of the first index in the world, Dow Jones could understand the market situation grace to a single number that reflected the impact of the factors influencing stocks’ price. If speaking about the nature of those factors, they were not only the ones related to the performance of the companies included in the index. They tend to be broader, as factors like upcoming wars, conflicts, recession, economic expansion also affect the stock price. This function is especially noticeable in stressful times when an index by its value indicates the market sentiment. b) Performance measurement Having an available, appropriate index has been from the very beginning of its creation a widely used instrument to measure performance, compare and evaluate the work of a manager. Most professionals activating in the investment industry consider that measuring the performance against a benchmark is vital. It is right that benchmarking allows investors to monitor the performance of a manager and even helps them with the decision of hiring or firing him. Undoubtedly, benchmarking helps identifying managers able to generate higher revenues. However, we should not forget about the time horizon if we want a sustainable good preformance rather than focus on short-term successful performance of certain asset managers. That is why the decision making process should be regarded in a long-term perspective, which should not be underappreciated. c) Measuring asset class performance and setting assset alocation policy The information a well-constructed index can provide about a particular asset class performance is extremely valuable. It shows the behavior of a security or an asset class over time and allows the calculation of long-run rates of return. In addition, index permits to calculate the risk and the changes in risk of an asset class, correlations and other indicators relevant for the investment and asset allocation policy.

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d) Indices as the basis for investment vehicles Taking into account several theories that proved the difficulty to beat the market with low risk, there has been developed an interesting alternative called index funds. Beside being a low-cost option for investors, it also reduces their stress of investing in high-cost funds that might underperform and do not meet their expectations. Moreover, another revolutionary concept called index-based products gains popularity due to its easy-to-follow technique and transparency for investors.4

1.3 Factors of relevance In order to have a relevant index that will provide us real, current and trustworthy information about a chosen market or sector, there are several factors that should be taken into account. The first thing to consider is the base dimension (or the number of securities in the base of the index). If we want the index to reflect the economic situation of a country for instance, we have to include in its base as much securities as possible. However, one has to consider that calculating an index with a big number of titles (securities) is costly and difficult, that is why it is optimal to find a rational number of representative securities and to follow them. Another important factor is the representativeness of the base, as an index has to incorporate securities of companies from different sectors and with different market capitalization if it wants to be closer to the market situation.

In order to make an index easy to interpret and follow, it is reccomendable to keep it in units that are comprehensible and comparable. As an index has to be as close as possible to real market situation, it has to be updated daily and made available to public regularly. As for the technical aspect, if an index is calculated based on the mean, it is essential to decide if to use either the arithmetic or the geometric mean. Compared to the simple arithmetic mean, the geometric one has the capacity to smooth the excessive fluctuations of index data.5

4 SCHOENFELD A., Steven. Active Index investing, maximizing portfolio performance and minimizing risk through global index strategies. Hoboken, New Jersey: John Wiley and Sons, Inc., 2004. 688 p. ISBN 0-471-25707-9, pp. 65-73. 5 VESELA, Jitka. Investování na kapitálových trzích. Prague: ASPI, 2007. 704 p. ISBN 978-80-7357-297-6, pp. 77-78. 11

Chapter 2 Index construction

2.1 Key criteria for an effective index An investor chooses an index to follow according to his array of needs. This choice is sometimes difficult that is why he has to look at the characteristics of the index and see if it provides the required information. However, there are several main criteria to define a well-constructed index. Schoenfeld defines seven of them, which are:

1) Completeness – meaning that an index has to reflect a wide range of investment possibilities. It has to take into account both the territorial factor and the choice of which companies to include. Schoenfeld assumes that this is the most significant criterion, as the more an index manages to cover the targeted asset class, the bigger is its utility for investors following this index.

2) Investability – questionning if an index includes all the listed stocks of a company or just those stocks that are publicly available. The investability criterion comes in contradiction with the precedent criterion, so an investor has to make a choice between a complete index and an index who reflects the situation of only purchasable stocks.

3) Clear, published rules and open governance structure – showing the importance of having well- established and clear rules based on which the index is constructed. The calculation methods of the index have to be comprehensible and, in addition, always publicly available.

4) Accurate and complete data – pointing out the quality of the data included in the index. Besides being accurate and complete, a minimum set of information related to the constituents of the index, which might suffer some changes over time, and the source of the data used should be publicly available.

5) Acceptance by investors – supposing that it is not enough for an index to be calculated, but also to be accepted and used by investors.

6) Availability of crossing opportunities, derivatives and other tradable products – implying that an index should be the right tool for index-based products. Index is playing as well an outstanding role in crossing opportunities, which allow matching buyers and sellers with considerably lower costs.

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7) Relatively low turnover and related transaction costs – meaning that it is preferable for an index to have lower turnover (less changes in its consitutents), thus not generating huge, costly rebalancing costs for the organization that is calculating it.6

2.2 Index weighting methods There are different ways of attributing a stock its weight in a certain index. According to the weighting type of index construction, we can distinguish three major groups of indices, which are: price weighted, value (or market cap) weighted and unweighted stock indices.

In a price weighted stock index, the price of its stocks (components) is the only thing that influences the index trading price. This obviously means that the stocks that have a higher price will have a bigger capacity to influence the index than the ones that are traded cheaper. In spite of this fact, two of the most important stock indices, Dow Jones Industrial Average and Nikkei 225 are calculated after this method.

When speaking about the value weighted index, another important parameter is included. The weight of a stock in the index is determined by the price of the stock multiplied by the number of outstanding shares (market capitalization). In this case, the companies with a larger market capitalization will have a bigger impact on the movements of an index.

Lastly, an alternative of the weighted indices are the unweighted stock indices. All the titles included are given the same weight. This method leads that each title will have the same effect on the index regardless its market capitalization or price.7

Choosing the best method of construction is controversial as all of them have their light and dark sides. If considering the value weighted index, it is clear that the market capitalization of a company is a significant indicator. However, it tends to give priority to big companies and reduce the importance of the smaller ones. Another important point to mention is that in some countries (e.g. Czech Republic, Austria) a small group of companies operating in key sectors represents the biggest part of the index, limiting the importance of smaller companies. A solution to this problem is implemented for example by the German DAX, which established a limit of 10 % per each title. A different option to solve this issue it to use the free-float adjustment technique, which defines how many stocks are publicly available, so giving a better

6 SCHOENFELD A., Steven. Active Index investing, maximizing portfolio performance and minimizing risk through global index strategies. Hoboken, New Jersey: John Wiley and Sons, Inc., 2004. 688 p. ISBN 0-471-25707-9, pp. 82-85. 7 KENNEDY, Mark, 2014. Different types of weighted indexes. Exchange traded funds [online]. Available at: http://etf.about.com/od/etfbasics/a/Different-Types-Of-Weighted-Indexes.htm [Accessed 22 February 2014]. 13

reflection on the situation of a component in the index.8 This technique is going to be discussed in details a few chapters below.

After agreeing that the price weighted indices give preference to high-priced stocks and that value weighted indices advantage the companies with high market capitalization, we might think that equal weighted indices (unweighted) is a good replacement option. However, this conclusion is wrong. First of all, the equal weighted index implies a too frequent rebalancing procedure needed to maintain the weight of each stock due to its usual change in price. Secondly, giving the same importance to each company would be inapproprite, as each company has a different contribution to economics. This would also mean that the amount appointed to each sector of economics depends only on the number of companies of the same sector chosen to be included in the index. Therefore, if an index comprises a considerable number of small companies from one sector and only a few big companies from another, the first sector will be overrepresented in the index. Lastly, the differences in the size and capital absorbtion possibilities of the companies just make impossible the operation of such an index on a very large scale.9

2.3 Index construction guidelines Since the creation of the first index Dow Jones Industrial Average, there have occured multiple changes and improvements in the world of benchmarks. After understanding that a price weighted index is not properly reflecting the investment universe, a big attention was devoted to value weighted indices. But his switch was not enough. In the second decade of the 1970s, investors and managers claimed that broader indices comprising a huge amount of stocks (such as Standard & Poor’s 500 Index or Russell 3000 Index) do not fit their needs. They have emphasized the importance of creating indices according to different investment styles and capitalization cathegories.

Since that period, a variety of indices has appeared, aiming at reflecting every sector, industry or subindustry. Interesting is the fact that the methodology of calculating an index has much to say about the index result. It happens that two different indices that are calculating the evolution of the same market sector can deliver different outcomes.

A crucial idea about the creation of indices is mentioned in the article of Gus Sauter called Index Rex, where he underlines the importance of having a replicable index. He mentiones that the best index is the one that that measures the performance of the strategy chosen to reflect and not the one that gives the

8 Value weighted stock index: construction, problems and adjustments. Macroption [online]. Available at: http://www.macroption.com/value-weighted-stock-index-construction-problems-adjustments/ [Accessed 22 February 2014]. 9 ARNOTT D., Robert; HSU C., Jason; WEST M., John. The fundamental index: a better way to invest. Hoboken, New Jersey: John Wiley and Sons, Inc., 2008. 311 p. ISBN 978-0-470-27784-3, pp. 68-71. 14

highest return. In order to create such an index, he proposes several key rules that would lead to a better index construction. First of all, he accentuates the objectivity and the rule-based approach of choosing the stocks in the index. Even though obeying a set of rules can generate higher turnover and needed rebalancing costs, it is still fundamental to maintain the style integrity of an index and do not fall in the trap of subjective decisions.

The weighting system deserves a special attention in connection with the investability criterion. When choosing which company should be included in an index, we have to consider all the company’s outstanding shares, as the size and importance of the company is influencing the performance of the stock. However, when attributing this company its weight in the index, it is highly reccomendable to revise the number of stocks that are actually available to the investment public (the so called free-floating criterion).

Not negligeable is the concept of the relativity of the market capitalization. The majority of the indices today are value weighted, which means that the market capitalization is the key factor and has to be periodically reviewed to reflect the performance of the chosen segment. However, Sauter proposes the idea of considering the market capitalization as a relative indicator, thus reducing the rebalancing costs generated by a possible new weighting of the company. This means that there should not exist a precise boundary, for instance, between a large-cap and a mid-cap. A stock should migrate from one cathegory to another only if compared to others it changes its position but not in case all of them proportionally do so. This practice reduces the turnover and offers investors a better understanding of companies’ classification.

Last but not least, is the comprehension of two terms considered complementary – value and growth stocks. It is erroneous to think that a stock can be only either value or growth. When evaluating a stock, value managers and growth managers pay attention to different indicators (price/earning, price/book, dividends for value managers and earning, sales, margin growth for growth managers). Their analysis can conclude the existence of pure value or pure growth stocks, but also of neither value nor growth and both value and growth stocks. A style-based index has to take into consideration these combinations, rather than strictly delimitate between value and growth stocks.10

10 SAUTER, Gus, 2002. Index Rex. Journal of indexes [online]. Available at: http://www.etf.com/publications/journalofindexes/joi-articles/1411-index-rex.html?fullart=1&start=6 [Accessed 21 February 2014]. 15

2.4 Index adjustment As previously mentioned, indices should be regularly updated. The constantly changing situation on the market and the occurance of different events should be reflected in the index. Some of the most important adjustments an index suffers are:11 a) Change of basis Changes in the basis of an index are caused by factors of different nature, for example changes in the economics of a country, sector changes (new creation and dissapearance of companies or sectors) or company changes (changes in the market capitalization of a company, augmentation or decline of traded stocks). An index should adapt in order to be as close as possible to the market reality. b) The split Stock split is a method when a stock with a bigger nominal value is split into several stocks with a smaller nominal value. From an investor’s perspective who owns a particular number of stocks, splitting does not affect the total assets’ price, in spite of the increased number of stocks and their different price. Usually companies use the method of splitting their stocks either when their stock price is relatively high, thing that makes them less liquid or when they expect a positive future profit.

The process of splitting depends on how an index is weighted. In case of price weighted indices the split causes an interesting effect. It gives importance to unsplit stocks and disadvantages the split ones, which is an irracional result. In case of the value weighted indices the result is favorable. As splitting does not influence the whole market capitalization of the company and the new prices mutually compensate with the new number of stocks, there are no changes in the index. On the other hand, one can expect that splitting might have a positive effect on the market (due to the increased liquidity), thus causing the rise of the stock price. c) Stock replacement Stock replacement is a common procedure due to mergers, takeovers, listing or delisting of a certain company. The replacement can have various effects on the value of the index as new securities of the included companies might behave different from the old ones.

11 VESELA, Jitka. Investování na kapitálových trzích. Prague: ASPI, 2007. 704 p. ISBN 978-80-7357-297-6, pp.80-82. 16

2.5 Free-Float Weight

The Free-Float Weight (FFW) represents the weight of the total listed shares that are available to the investing public. It is an important criterion used by a significant number of indices. The calculation of the free-float value begins by the estimation of the non-free-float shares, which are the shares that are not freely available to the public. The data about the non-free-float shares can be extracted from the securities reports or from the documents that are published by the listed companies. The FFW is calculated using the formula below and it can reach a value between 0.00000 and 1.000000.

FFW = 1* (1- Non FFW), where Non FFW represents the result of Non-Free-Float Shares divided by the number of listed shares.12

12 Tokyo Stock Exchange, 2012. Tokyo Stock Exchange Index Guidebook. [pdf] Tokyo: Tokyo Stock Exchange. Available at: http://www.tse.or.jp/english/market/topix/b7gje60000003v3u-att/b7gje60000006cm3.pdf [Accessed 20 December 2013]. 17

Chapter 3 Japanese stock indices

3.1 Japanese stock indices Stock indices began being calculated in Japan after the Second World War. Their importance go further Japanese market and they are widely used all over the world. Due to the complex stock market, there are different types of indices calculated in Japan, taking into consideration aspects like size, style, strategy, sector, etc. This thesis focuses on the most popular Japanese indices which are Nikkei Average and TOPIX. It is important to mention that due to limited space only the “classic” version of these two indices is going to be analyzed. Each of these indices has sub-indices and other indices that derive from the initial version.

Tokyo Stock Exchange (TSE) is the institution that nowadays calculates over 15 different main indices tracking different types of stocks. Beside TOPIX, which is calculated from the stocks on the First Section, TSE calculates indices based on shares from the Second Section, the Mothers market, the JASDAQ market and REIT market. It has also a wide variety of sector and market capitalization-based indices. Among price indices, TSE calculates several performance indices, which take into consideration dividends.13 Annex A offers a better comprehension and a complete image of the indices calculated by TSE.

Nihon Keizai Shimbun (Nikkei Inc.) is a leading economic newspaper in Japan that publishes one of the most important and old indices in the world, Nikkei Stock Average (known as Nikkei 225). Except the main index, it calculates Nikkei derived indices and other indices based on criteria like dividend investment, strategy, volatility, as well as bonds and commodity indices.14 Annex B gathers all the indices calculated by Nikkei Inc. at the moment.

There are also indices such as MSCI Japan Index and the FTSE Japan, who track Japanese stock market but that are calculated by foreign financial institutions.15

13 Indices. Tokyo Stock Exchange [online]. Available at: http://www.tse.or.jp/english/market/topix/index.html [Accessed 30 March 2014]. 14 Nikkei Indexes. Nikkei Indexes [online]. Available at: http://indexes.nikkei.co.jp/en/nkave/index [Accessed 30 March 2014]. 15 ENDO, Nobuya, 2013. Japanese benchmarks The Nikkei and the TOPIX Face-off. [pdf] State Street Global Advisors. Available at: http://www.ssga.com/library/povw/516936_Japanese_Benchmark_The_Nikkei_and_the_TOPIX_Face_OffCCRI1362694345.p df [Accessed 20 February 2014]. 18

3.2 Nikkei Stock Average Introduction The calculation of the world-wide popular index, Nikkei Keikin Kabuka16 (called Nikkei Average or Nikkei 225) began on September 7, 1950. At the beginning, Nikkei 225 was retrospectively calculated back to May 16, 1949, date that marks the reopening of Tokyo Stock Exchange after the Second World War. Initially, it had been calculated by Tokyo Stock Exchange (TSE). However, since 1970, the economic newspaper Nihon Keizai Shimbun was the institution in charge of calculating it.17

Constituents Nikkei Stock Average consists of 225 domestic common stocks listed in the first section of Tokyo Stock Exchange. The index does not include ETFs, REITs, preferred securities, preferred stocks or tracking stocks.18 Nikkei has 6 main sectors and 36 subsectors. For a detailed Nikkei’s sector and subsector classification and the number of titles included in each of it see Annex C.

Constituents’ changes The constituents are subject to a “Periodic Review” and an “Extraordinary Replacement” review. The Periodic Review takes place once a year at the beginning of October and its main goal is to maintain the market representativeness of its components by making any changes needed.

After this revision, stocks with high liquidity may be added, while the less liquid stocks may be removed from the index. The liquidity of a stock is judged according to two indicators: trading volume and magnitude of price fluctuation by volume, the latter calculated as (high price/low price)/volume. The procedure of selecting liquid stocks comes in two phases. First, there are chosen 450 top liquid stocks of the first section of TSE, the so called “High Liquidity Group”. If any current component does not figure on this list, it is removed from the index. Second, another list of top 75 most liquid stocks from first section of TSE is created. If any of those extremely liquid stocks ranked 75th or higher is not yet in the index, it is included.

However, liquidity is not the only criterion of including or deleting stocks in Nikkei 225. The Periodic Review regards the aspect of sector balance, based on the number of constituents in each sector, so that none of them is over or under represented. Technology and Materials sectors are the most represented in the index if judging from the number of companies. This was to be expected as Nikkei was primarily

16 Keikin Kabuka (jp) means “Average stock price” 17 Nikkei Indexes, 2011. Nikkei Stock Average Index Guidebook. [pdf] Tokyo: Nikkei Inc. Available at: http://indexes.nikkei.co.jp/nkave/archives/file/nikkei_stock_average_guidebook_en.pdf [Accessed 20 March 2014]. 18 Same as 17 19

founded to envisage the industrial situation of Japan. The final decision about changes of constituents is taken by Nikkei Inc. after consulting a committee of academics and market professionals.

If speaking about the Extraordinary Replacement revision, it is mainly intended to review the situation incurred due to specific events that require the delisting of some stocks. It is not applied when we want to simply add a new constituent and delete another. Company delisting comes in certain cases, such as mergers, bankruptcy, liquidation, share transfer, share exchange, excel debt, transfer to second section, etc. The Extraordinary Replacement is scheduled depending on these events. The procedure of replacing delisted securities and adding new ones is generally based on selecting by liquidity and sector balance criteria, procedure that was described above.19

Calculation method Nikkei 225 is a price weighted index. Before calculating it, the stock price is adjusted as indicated below.

Adjusted stock price = stock price * 50 (yen) / presumed par value (yen) Nikkei Stock Average = sum of Adjusted Stock Price / Divisor

Before the revision of the Commercial Law in 2001, Japanese stocks had par value. In spite of the abolishment of this system, nowadays many stocks’ prices are derived from the ex-par value, most common values being 50, 500 or 50 000 yen. What Nikkei is doing is to adjust the prices of the constituents to a presumed par value of a 50 yen base. Even though the majority of the constituents have a presumed par value of 50 yen, there are some exceptions. For instance, Sumitomo Mitsui Financial Group, Inc. has a par value of 500, while Honda Motor Co., Ltd has a par value of 25.20 In case of stock split, the par value will change (e.g. if a stock with a 50 yen presumed par value goes 1 to 2 split, the new par value will be 25). The changing of the par value when a stock splits permits to keep the divisor intact.

Due to the changes in the constituents and stock splits, the divisor has to be periodically modified in order to keep the continuity of the index. The adjustment of the devisor is based on the Dow method. Devisor is reviewed in two cases: either when there are changes in the constituents and the sum of stock prices changes, or in case of corporate actions such as split, reverse split, paid-in capital increase. However, in case of reverse split in large scale, the devisor remains unchanged, while the presumed par value is adjusted.

19 Nikkei Indexes, 2011. Nikkei Stock Average Index Guidebook. [pdf] Tokyo: Nikkei Inc. Available at: http://indexes.nikkei.co.jp/nkave/archives/file/nikkei_stock_average_guidebook_en.pdf [Accessed 20 March 2014]. 20 Nikkei Indexes, 2011. Nikkei Stock Average Par Value. [pdf] Tokyo: Nikkei Inc. Available at: http://indexes.nikkei.co.jp/nkave/archives/file/nikkei_stock_average_par_value_en.pdf [Accessed 20 March 2014]. 20

The devisor is calculated as: Divisor tomorrow = Divisor today * sum of base prices for the next day constituents / sum of “closing prices” of today’s constituents

Since 2010, Nikkei 225, whose values are displayed in Japanese yen, is calculated every 15 seconds of the trading hours of the TSE.21

Evolution Graph 1: Nikkei Stock Average’s evolution since creation

(point) Nikkei 225 evolution 50000 40000 30000 20000 close price 10000 0 1949 1954 1959 1964 1969 1974 1979 1984 1989 1994 1999 2004 2009 2014 (year)

Source: Author, based on historical annual data provided by Nikkei Indexes, , retrieved on 20.03.2014

3.3 TOPIX Introduction Tokyo Stock Price Index, known as TOPIX is a Japanese index calculated by Tokyo Stock Exchange (TSE). It comprises domestic common stocks listed on the First Section of TSE. Compared to the price weighted Nikkei 225, TOPIX is a market capitalization index. Its calculation started on January 4, 1968 with a base point of 100.22

Constituents TOPIX is made of around 1700 constituents. Its constituents are organized in 17 categories that classify the 33 sectors according to the industrial sectors defined by the Securities Identification Code Committee. Furthermore, this division permits the calculation of TOPIX sector indices and of TOPIX 17 series.23 For a detailed sector classification see Annex D.

21 Same as 17 22 Indices. Tokyo Stock Exchange [online]. Available at: http://www.tse.or.jp/english/market/topix/index.html [Accessed 20 March 2014]. 23 Same as 22 21

Constituents’ changes Contrary to Nikkei 225, TOPIX does not need to make annual reviews of the constituents. This is due to the fact that TOPIX comprises all domestic common stocks listed on the First Section of Tokyo Stock Exchange, and eventual changes will occur only in case of companies’ listing or delisting on this section.24

Calculation method Previously, TOPIX was calculated every 15 seconds through the TSE Market Information System. However, since September 13, 2010, TOPIX calculation interval became 1 second. Contrary to Nikkei 225, TOPIX implements the free-float adjustment technique. This is taking into account when establishing the current market value. The current market value (CMV) represents the sum of the price multiplied by the number of free-float adjusted shares of the constituents. TOPIX is calculated according to the formula:

TOPIX = CMV/BMV * Base point where - CMV represents the current free-float adjusted market value - BMV stands for the base market value

The value of TOPIX is expressed in points. The base point of TOPIX is 100. However, 9 out of those 33 sector indices that are part of TOPIX have a base point of 1000. As changes in the number of constituents and public offerings have no connection with the stock market fluctuation, the necessary adjustments are made to the base market value (BMV) rather that to the current market value (CMV). Among the events that require the adjustment of base market value are: initial listing, assignment to the TSE First Section from the TSE Second Section, delisting, reassignment from the TSE Second Section to the TSE First Section, etc. This will maintain the continuity of the index.25

The number of shares for index calculation represents the number of listed shares for index calculation multiplied by the free-float value. Usually, the number of listed shares for index calculation and the number of shares issued does not differ. Nevertheless, there are cases like stock split, when these values might not coincide. Another example of discrepancy between these two values is the case of Nippon Telegraph and Telephone Corporation and Japan Tabacco Inc. For these two companies, the number of outstanding shares does not coincide with the number of listed shares for index calculations because a part of the shares are held by the government and this part is not included.26

24 TOPIX and Nikkei225. Tokyo Stock Exchange [online]. Available at: http://www.tse.or.jp/english/market/topix/comparison.html [Accessed 20 March 2014]. 25 Tokyo Stock Exchange, 2012. Tokyo Stock Exchange Index Guidebook. [pdf] Tokyo: Tokyo Stock Exchange. Available at: http://www.tse.or.jp/english/market/topix/b7gje60000003v3u-att/b7gje60000006cm3.pdf [Accessed 20 March 2014]. 26 Same as 25 22

Free-float weight (FFW) is calculated as: FFW = 1* (1- Non FFW), where the Non FFW represents the non-free-float shares divided by the number of listed shares. The free- float weight is revised one a year; however in case of the occurrence of significant events TSE might conduct an extraordinary review. A few examples of such events are: allocation of new shares to a third party, company spin-off, conversion of preferred shares or exercise of subscription warrants, merger, stock swap, take-over bid, etc. As a general rule, the following shares are considered by TSE not to be free- float: “shares held by the top 10 major shareholders, treasury stocks, shares held by board members and other shares deemed by TSE to be unavailable for trading in the market.”27

In 2004, Tokyo Stock Exchange announced its intention to apply free-float weight methodology on TOPIX and on other TOPIX related indices. This decision was mainly directed to index funds, whose number increased in that period. Free-float adjustment methodology benefices index funds by helping to reduce the discrepancy between share prices’ demand and supply. Since 2006, TOPIX applies free-float weighting. For those interested in a benchmark reflecting total market capitalization, TSE is publishing Ex-TOPIX, which has the same features as TOPIX except the fact that it is not free-float adjusted.28

Evolution Graph 2: TOPIX’s evolution since creation

Source: Tokyo Stock Exchange, , retrieved on 20.03.2014

27 Same as 25 28 Tokyo Stock Exchange, 2005. TOPIX moves to Free-Float. [pdf] Tokyo: Tokyo Stock Exchange. Available at: http://www.tse.or.jp/english/market/topix/b7gje60000003v3u-att/pamphlet-e.pdf [Accessed 20 March 2014]. 23

3.4 Japanese indices comparison There has always been a debate among investors all over the world on which Japanese index better reflects Japanese economy and shall be used in different investment products. This chapter will try to compare and evaluate the methods of construction of Nikkei 225 and TOPIX. The comparison is mainly going to be focused on the following criteria: 1) Provider 2) Issue composition and number of constituents 3) Sector differences 4) Calculation methodology 5) Base revision 6) Unit 7) Usage 8) Costs Before proceeding to the comparison, I would like to mention that the dividend reinvestment criterion is not going to be regarded, as neither Nikkei 225 nor TOPIX are performance indices.

Nikkei 225 and TOPIX are nowadays calculated by two different institutions. Initially, both Nikkei 225 and TOPIX had been calculated by TSE, however since TSE began calculating TOPIX, Nikkei 225’s calculation was taken by a daily Japanese economic newspaper. This is a good reason that explains the popularity of Nikkei 225 over TOPIX. Grace to Nihon Keizai Shimbun, Nikkei 225 had always a better visibility in media. These two Japanese indices are compared on financial markets with Dow Jones Industrial Average and S&P 500. Dow Jones’s methodology of construction and popularity is very similar to Nikkei’s. On the other hand TOPIX, which is much more complex and gives a better reflection of Japanese economy, is often compared to S&P 500.

If speaking about the companies included in the index, TOPIX with 1700 companies is exceeding several times Nikkei that has only 225. Both indices have in their composition companies listed on the First Section of TSE. Judging from this fact, TOPIX is much more diversified and complete. It offers a better Japanese market representation. However, some investors claim that the large number of constituents can sometimes generate liquidity problems for TOPIX.29 On the other side, Nikkei 225 does not face liquidity problems, as one of the main index inclusion criteria is the liquidity of the stock.

29 ENDO, Nobuya, 2013. Japanese benchmarks The Nikkei and the TOPIX Face-off. [pdf] State Street Global Advisors. Available at: http://www.ssga.com/library/povw/516936_Japanese_Benchmark_The_Nikkei_and_the_TOPIX_Face_OffCCRI1362694345.p df [Accessed 20 February 2014].

24

Overall, there are no big differences in the sector allocation of each index. Nevertheless, there are a few remarks to be made. As showed in table 1, the most significant weight difference is in the financial sector, where TOPIX clearly surpasses Nikkei 225 with more than 11 %. On the other hand, the Information Technology sector is given more weight in Nikkei 225, with an overexposure of around 4 %. As it was mentioned above, Nikkei 225 is paying a special attention to sector balance when selecting the stocks in the index, while TOPIX is just replicating the stocks that have met the criteria to be listed at the First Section of TSE.

Table 1: Sector allocation comparison Nikkei 225 TOPIX Nikkei 225 TOPIX Sector Weight (%) Weight (%) Number of companies Number of companies Consumer Discretionary 21.41 19.44 30 376 Consumer Staples 7.54 7.13 18 145 Energy 0.55 1.41 3 23 Financials 7.80 19.34 28 167 Health Care 8.74 5.99 10 76 Industrials 24.96 21.66 66 459 Information Technology 15.37 11.00 26 242 Materials 7.11 7.48 35 185 Telecommunication Services 6.16 4.09 4 4 Utilities 0.36 2.46 5 17 Total 100.00 100.00 225 1694 *As of December 31, 2012 *Note: the sector allocation data above is not identical with the sector classification of each index Source: Author, based on data from Figure 1 of Japanese benchmarks The Nikkei and the TOPIX Face-off, State Street Global Advisors, , retrieved on 20.03.2014

The most significant differences come in the calculation methodology of each index. We are speaking about TOPIX, which is a value weighted index and Nikkei 225, which is one of the few price indices remaining in the world. I consider the market capitalization weighting of TOPIX as a better weighting method for an index. It offers a more accurate representation of the importance of each company in the index and better reflects the overall Japanese stock market. The price weighted Nikkei 225 is too sensitive to price deviations of the stocks. Futhermore, I see the fact that TOPIX applies free-float weighting as an important advantage. The free-float adjusted TOPIX is allowing investors to have a better image of the available stocks on the market.

25

The base revision is another issue where these two Japanese indices vary in methodology. In case of Nikkei, constituents are subject to a Periodic Review and to Extraordinary Replacement reviews. Both these reviews are selecting stocks based on their liquidity and taking into account the sector balance. The final decision is made by a special committee of academics and market professionals. On the other hand, TOPIX does not have any constituents’ review except the free-float weighting review, held once a year. This is due to the fact that its components are automatically included in the index if they meet the requirements to be listed on the First Section of TSE. In my view, the constituents’ revision of TOPIX is more transparent than Nikkei’s. Grace to the link between TSE and TOPIX, its constituents are subject to well-established TSE listing rules. There are no exceptions or subjective inclusions.

On the contrary, even though Nikkei 225 respects the pre-established criteria, there is place for doubts. For instance, the fact that the sector balance is the second criterion made me think that some companies might not be included even if they are liquid, just because Nikkei follows sector balance, or vice versa being less liquid, but included for fitting the sector balance. Moreover, as mentioned before, Nikkei has a special committee that decides upon the constituents’ deletion or addition, thing that makes it less objective and transparent for the large public. This problem does not occur with TOPIX, where the TSE First Section criteria are made for every company listed and there is no committee that can influence it. Once a company does not fulfill the requirements, it goes to the Second Section where it is going to be a constituent for another TSE index.

Apart from the above mentioned differences, TOPIX is calculated in points and Nikkei 225 is calculated in Japanese yen. Point calculation of TOPIX seems much more simplistic, while Nikkei’s yen calculation generates possible questions about the exchange rate sensitivity of the index to the Japanese currency. Another dilemma specialists have tried to explain is the changing correlation between the Japanese yen and Nikkei’s performance. Before the crisis, there was a negative correlation between the index and the Japanese yen, meaning that if the yen depreciates, Nikkei will rise. However, in the last years this negative correlation has become positive. One of the possible explanations of this correlation change is the reaction of the Japanese economic and financial systems to the government’s efforts to solve the deflation issue.30

Both TOPIX and Nikkei are used nationally and internationally. Nevertheless, TOPIX is seen as a “leading economic indicator” and it is widely used by Japanese government. It is also preferred by Japanese pension funds and investment trusts grace to its complexity and transparency.31 Another reason

30 A breakdown of the Yen-Nikkei correlation? Prudent investor newsletters [online]. Available at: http://prudentinvestornewsletters.blogspot.cz/2013/08/a-breakdown-of-yen-nikkei-correlation.html [Accessed 6 April 2014]. 31 TOPIX and Nikkei225. Tokyo Stock Exchange [online]. Available at: http://www.tse.or.jp/english/market/topix/comparison.html [Accessed 6 April 2014]. 26

why long-term investors tend to choose TOPIX over Nikkei is Nikkei’s price weighting calculation, leaving space for misrepresentation of some companies. A relevant example is Fast Retailing Co., which was given 10 % weight in Nikkei in 2013, while only having been the 44th biggest Japanese company according to market capitalization. Yet, Nikkei is the most traded Japanese index. This is probably due to the international investors’ recognition and visibility in media. Some of the Nikkei’s based derivatives such as options offer a greater liquidity than TOPIX’s options.32

Unfortunately, there is no official data about TOPIX and Nikkei’s calculation costs. We can only suppose that TOPIX calculation costs are higher than Nikkei’s, due to the large number of constituents (1700 vs. 225). From an investor’s point of view it is less costly to perfectly track Nikkei 225 than TOPIX.

Lastly, I would like to end with the last decade’s Nikkei and TOPIX performance. From the chart below, you can see that before the crisis, both indices had almost the same performance. However, after the crisis the situation has changed in Nikkei’s favor, which was and is considerably outperforming TOPIX. Trying to find an explanation, I can assume that this issue might be caused by certain sector differences. I consider that the overexposure of TOPIX to financial sector (with over 11 % compared to Nikkei) had a noticeable impact on TOPIX evolution. The crisis recovery of the Japanese financial sector might have been slowing TOPIX performance.

Graph 3: Nikkei 225’s relative performance versus TOPIX (2005-2014)

Source: Author with minor format modifications, based on data and chart draw options of bigcharts.marketwatch.com, retrieved on 28.03.2014

32 BOUSSER, Thimothee, 2013. A closer look at TOPIX. The asset [online]. Available at: http://mobile.theasset.com/inside.php?tid=24654 [Accessed 6 April 2014]. 27

The table below summarizes the main points described above and comprises the current index values.

Table 2: Comparison of Nikkei 225 and TOPIX Summary Criteria TOPIX Nikkei 225 Provider Tokyo Stock Exchange Inc. Nihon Keizai Shimbun (Nikkei Inc.) Economic newpaper Year of creation 1968 1950 Base value 100 points 176.21 yen Issue composition All companies listed on the First 225 companies listed on the First Section of TSE Section of TSE Number of constituents Around 1700 225 Methodology Free-float adjusted Average price weighted Market capitalization weighted Base revision No constituents’ review due to TSE Periodic Review (once a year), First Section listing rules, free-float Extraordinary Replacement review value review once a year Unit Point Yen Calculation interval 1 second 15 seconds Current index value (as of 10.04.2014) 1 149.4933 14 300.1234 Source: Author

3.5 The joint index JPX-Nikkei Index 400 There was always a debate on which Japanese index is better and more representative. Some claimed that TOPIX comprises too many stocks, others that Nikkei is old-fashioned and less transparent. As we could see, both indices have their pros and cons. This year has brought an interesting solution to the polemic discussions over the superiority of those two Japanese indices. To be more precise, a new Japanese joint index has been created. The new index is called JPX-Nikkei Index 400 and it is jointly calculated by Nikkei Inc., Tokyo Stock Exchange and Japanese Exchange Group. It has 400 constituents selected from the First and Second Section of TSE, as well as from the Mothers and JASDAQ markets. Currently, the biggest part of the constituents (388 out of 400) are stocks listed on the First Section.

Index calculation started this year, on January 6, 2014, however the base date was chosen to be August 30, 2013. Its base value is 10 000 points and similarly to TOPIX, it is calculated every second of the trading hours of TSE. JPX-Nikkei Index 400 is a market capitalization index whose stocks are free-float adjusted.

33 TSE first section issues. Google finance [online]. Available at: https://www.google.com/finance?q=INDEXTOPIX%3ATOPIX&ei=htlGU6DvD8aDwAPFJA [Accessed 10 April 2014]. 34 Nikkei 225. Google finance [online]. Available at: https://www.google.com/finance?q=INDEXNIKKEI%3ANI225&ei=i9lGU5DELcGkwAOOxgE [Accessed 10 April 2014]. 28

The components are revised once a year during the Annual Review held in August. The stocks are selected based on the last three years trading volume and market value. Moreover, it takes into account things like the three-year ROE and cumulative operation profits. Lastly, stocks are ranked based on qualitative factors such as corporate governance.35

This index represents a real combination of features between TOPIX and Nikkei. It comprises an optimal number of constituents, being somehow between those two giants. It is calculated after the same methodology of TOPIX but it has more intricate selection criteria, thing that makes it resemble to Nikkei. Last but not least, as this index is a joint project between Japanese Exchange Group, TSE, and Nikkei Inc., we can expect a higher visibility in media grace to Nikkei’s implication.

35 Tokyo Stock Exchange, 2014. JPX-Nikkei Index 400 Factsheet. [pdf] Tokyo: Tokyo Stock Exchange. Available at: http://www.tse.or.jp/english/market/topix/b7gje6000001ns00-att/b7gje6000001rsua.pdf [Accessed 6 April 2014]. 29

Chapter 4 Index investing

4.1 Index investing – active vs. passive It seems that the famous and perpetual debate between adepts of active and passive investment strategies will never reach a trade-off. Active management is based on the principle that the price of some stocks available on the market does not reflect their intrisic value. Active managers are actively searching for stocks that are underpriced to include them in their portfolios. Therefore, if indeed a stock is undervalued, the manager will gain a better return than the benchmark. In order to identify the mispriced stoks, an ample research is required. On the other hand, passive management regards the price of the stocks as being fair and does not see any major discrepancy between stocks’ intrisic value and their price. Passive investment strategy is not intending to outperform the market. It chooses passive strategies (e.g. index funds) that would provide returns as those of the benchmark’s.36

Active managers are persuaded that it is possible to beat the market giving the example of Warren Buffett’s success. Passive investors, rather than trying to beat the market, are satisfied with reaching average market returns. It is right that active investing and active funds have a much longer history than the passive investing who has appeared only in 1970s. When choosing among these two strategies, active investing in given preference. Most people still think that the active managers they choose are talented and able to beat the market in exchange to the high fees charged. However, data proves the contrary and even if it is possible to reach greater returns with active investing, the fees paid to managers can reduce them. For instance, if an index fund charges an annual fee of 0.2 percent, an active fund is charging 1.2 percent. With the birth of passive investing and a wide range of indices all over the world, large public was provided an alternative. They can now choose between the low-costs index funds and exchange-traded funds (ETFs).37

There is a well-established prejudice that passive investing is a boring investment approach. Index investing and index-based products as part of passive investing are also regarded to be tedious. As a reaction to this malconcept, a series of arguments has been developed showing that indexing can be active as well.

36 ARNOTT D., Robert; HSU C., Jason; WEST M., John. The fundamental index: a better way to invest. Hoboken, New Jersey: John Wiley and Sons, Inc., 2008. 311 p. ISBN 978-0-470-27784-3, pp. 44-46. 37 FERRI A., Richard. The power of passive investing: more wealth with less work. Hoboken, New Jersey: John Wiley and Sons, Inc., 2011. 264 p. ISBN 978-0-470-59220-5, pp. 3-14. 30

The first argument of the active index concept is that index construction and selection is active. Active decision making is required when selecting the securities that are going to be part of an index, when giving them the proper weight and when the index is being periodically rebalanced. Moreover, due to the expansion of index-based products, investors are constantly put in the situation to make decisions connected to those products or the choice of the benchmark.

Surprisingly for the large public, but managing index-based portfolios is also an active process. It implies a big dose of effort and competence to carry out a deep market microstructure analysis. Lastly, it is said that the use of index products is also active. Choosing among a wide variety of index-based products is as active as an investor wants it to be. It is particularly active to determine which index products to include in the portfolio and in what proportion.

The debate active versus passive is useless. No one tries to say that we have to choose only one strategy and apply it. On the contrary, it is advisable to combine these two options. This combination is an efficient way to maximize the performance of the portfolio while minimizing the risk. Indexing should not be regarded only as a subsitute, but rather as a appropriate tool to increase the efficiency of the portfolio.38

4.2 Factors contributing to the growth of indexing Indexing is an investment option that has gained popularity in the last decades. Even though in the 1970s indexing was seriously regarded only by academics, ten years later the situation has changed. Institutional investors began switching their attention to index investment opportunities. There have been four major factors that led to the growth of indexing, that are actually representing four great advantages of this investment strategy. These factors are: a) Ease in risk budgeting Risk is a key criterion for every investor. Besides considering the risk of an investment portfolio, an investor is also caring about the relative risk that his portfolio returns will deviate from a certain benchmark. An investor can choose to either replicate the benchmark or to invest in other shares except those comprised in it. In case he chooses the second strategy, his returns might deviate from benchmark’s returns. What index managers do is to copy the index, this being the only way to exclude the relative risk.

38 SCHOENFELD A., Steven. Active Index investing, maximizing portfolio performance and minimizing risk through global index strategies. Hoboken, New Jersey: John Wiley and Sons, Inc., 2004. 688 p. ISBN 0-471-25707-9, pp. 2-4. 31

b) Lower fees and costs Compared to the fees paid to an active manager, generally the fees charged by index managers are lower. If speaking about the costs, both active and passive managers have expenses, however, they are a bit different. The research costs of active managers are much higher, as they continuosly seek for a better investment, while index managers’ research costs are relatively lower. Moreover, due to his changing investment choices, an active manager meets higher turnover-related costs, while an index manager supports only the costs of portfolio adaptation related to index changes. Lastly, as mentioned before, indexing gives an incredibly valuable base to crossing opportunities. While active managers do not have access to crossing networks, index managers do have and by using them they save a big amount of transaction-related costs. c) Relative ease in choosing managers While choosing an active manager implies a more intricate selection procedure, the choice of an index manager is considered to be easier. First of all, because his main task is to replicate the benchmark. Second, because the benchmark offers an ideal criterion to evaluate his performance. d) Competitive performance against active managers History gives evidence that in both short and long-term investment strategy, benchmark’s returns are either close or above the returns of active managers.39

4.3 Index investment opportunities The 1970s represented a milestone in index investing. The first index fund launched in 1971 by Wells Fargo Bank and the first retail index fund lauched by Vanguard a few years later in 1976 gave the start of a new era in index industry. The 1980s not only brought some innovative products such as stock index futures and options, but also held the expansion of index funds. The next decade was fundamental in the development of index-based investment. The bull market of the 1990s was a perfect premise to strenghten the position of index funds and to increase their usage in Japan and Europe. This was also the time when the first Exchange-traded funds (ETFs) were introduced in the United States and Canada. ETFs became so popular that in the first four years of the twenty first century there occurred a global ETF explosion. Beside this ETF interest increase, the period between 2000 and 2004 brought a new technique considered to be the most important index change ever. We are speaking about the float adjustment, implemented by major global and local indices.40

39 SCHOENFELD A., Steven. Active Index investing, maximizing portfolio performance and minimizing risk through global index strategies. Hoboken, New Jersey: John Wiley and Sons, Inc., 2004. 688 p. ISBN 0-471-25707-9, pp. 32-37. 40 SCHOENFELD A., Steven. Active Index investing, maximizing portfolio performance and minimizing risk through global index strategies. Hoboken, New Jersey: John Wiley and Sons, Inc., 2004. 688 p. ISBN 0-471-25707-9, pp. 11-13. 32

There are several index-based investment vehicles, the most important being: a) Index funds b) Index certificates c) Index products - Exchange-Traded funds (ETFs) - Index based derivatives

4.3.1 Index funds An index fund is an investment fund whose strategy is to replicate the performance of an index. That is why index funds invest in assets which are included in a chosen reference index. Contrary to active investment funds, who will always try to beat the market, index funds do not aim at outperforming the benchmark.41

The four main advantages of index funds are: a) Liquidity and capacity The majority of index funds use indices that include large capitalization stocks. Grace to the fact that these stocks are large-cap, they are popular among investors, making them extremely liquid. This liquidity results in a big trading volume. Moreover, index funds have a huge capacity due to their investment in indices that track thousands of securities on the market. You may argue that active managers may also investing in liquid, large-caps stocks. However, their problem is that they focus on undervalued stocks only, thus being limited to fewer titles in their portfolio. b) Built-in diversification As indices were primarily designed to represent the whole market, it is clear that by their nature they offer a broader diversification. Having a large number of stocks included, indices like S&P 500 or Russell 1000 reflect a wide range of economic sectors and industries. c) Low turnover, low taxes Index funds through their passive strategy register a much lower turnover than active managers. Futhermore, this low turnover is an extremely valuable benefit when time comes to pay taxes. This thing occurs because index funds invest in indices, and indices generally does not show a high turnover. Usually, turnovers in indices are generated when a stock suffers some changes as a merger, acquisition or bankrupcy and it does not fullfill index criteria anymore. On the other hand, active investment implies constantly buying and selling stocks on the under/over valued principle, resulting in a high turnover. Besides, the capital gains and dividends which are subject to taxation make them less attractive compared to index funds.

41 SVOBODA, Martin. Indexové investice. Brno: Dimension a.s., 2001. 274 p. ISBN 80-238-7634-1, p. 54. 33

d) Ease in implementation and monitoring Index funds offer an easy way to follow the performance of their managers. The activity of index fund managers is also similar, as they all have the same portfolio strategy. Futhermore, issues like style drift, conflict-of-interest or discretion in decision making will not appear.42

The table below summarizes the main differences between the active investing strategy and index fund investing.

Table 3: The difference between Active and Index Fund investment strategies Subject Active Investing Index Fund Investing Return objective Beat a market Obtain the return of the market, index or asset class Style definition 40% drift from classification Pure and consistent classification Average equity individual 3.70% per year according to Dalbar for 20 S&P 500 = 13.20% annualized investor returns over 20 years year period ending 2004 Index portfolio 100 = 15.32% annualized Approach Stock picking, Time picking, Manager Buy and hold a globally diversified picking or Style drifting portfolio of index funds State of mind Stressed Relaxed Taxes and portfolio turnover High (20-40% of returns over 10 years) Low (less than 8% of return over 10 years) Turnover averaged 112% in 2004 Turnover averages 10% Net performance Well below the index by the amount of fees, The index return, less low fees, low taxes expenses, taxes and missed opportunities and tracking error Individual investors Currently about 85% of equity funds Currently about 15% and browing rapidly since 1999 Institutional investors Currently about 56% of domestic stocks Currently about 44% and growing assets Proponents Virtually all Brockerage Firms, Mutual Fund The Univ. of Chicago, Nobel Prize Companies, Market Timing Services, Recipients, Vanguard Group, Dimentional Investment Press and Brockerage Training Fund Advisors, Barclays Global Investors, programs Warren Buffet, and Charles Schwab & Company Analytical techniques Art - Qualitative, Disregard for Risk, Science – Quantitative, Risk Management, Forecasting, Predicting the Future, Feelings, Long-term Statistical Analysis, Accurate Intuition, Luck, Betting, Gambling, Performance Measurements, (like Speculation Insurance Companies) Source: HEBNER T., Mark. Index Funds: The 12-Step Recovery Program for Active Investors. Irvin, California: IFA Publishing, Inc., 2007. 394 p. ISBN 0-9768023-0-9, p. 6.

Looking from another angle, index funds have also some disadvantages to consider. For example, if you buy an index fund from a brockerage, you will be charged a considerable commission. You can avoid this commission if you use your own brockerage firm. Secondly, it is highly recommendable if you invest in an index fund not to trade it too often, but rather buy and hold, as index trading is costly. Thirdly, advisors claim that investing in a stock index is not a replacement for a genuine asset allocation strategy. In order

42 ARNOTT D., Robert; HSU C., Jason; WEST M., John. The fundamental index: a better way to invest. Hoboken, New Jersey: John Wiley and Sons, Inc., 2008. 311 p. ISBN 978-0-470-27784-3, pp. 49-54. 34

to reach a representative, diversified portfolio you may need various index funds that reflect different sectors, countries or asset classes (e.g. commodities, real estate).43

4.3.2 Index certificates Index certificates have been firstly introduced on the investment market in 1990. Despite their short history, index certificates are widely used among investors. This product allows investors to buy a whole stock index through a unique security. The certificate value can either fully correspond with the value of the index, or be expressed as part of the index, for instance 1/10, 1/100 or 1/1000. Generally, an index certificate has a fixed maturity date. When it has reached the maturity date, the certificate is paid according to the performance of the underlying index.

The main advantages of possesing index certificates are: a) Transparency – grace to their simple, easy-to-follow construction, index certificates are easily comprehensible by the large public. The certificate holder can always understand the value of his certificate by following index performance news, largely available in media. b) Continuous trading – these certificates can be traded continuously whenever the stock market is open. After its closing, certificates can be traded over-the-counter online. c) Affordability – index certificates are affordable instruments. It is considerably less costly to buy an index certificate than to create a portfolio comprising all the shares of the same index. d) Low transaction costs – the management fees charged on maturity are not elevated. Moreover, there are cases when index certificates’ management fees are equal to bonds’ management fees (for certificates traded in Germany, whose ISIN begins with 1, 2, 3, and whose charged fees are 0.5 % instead of 1 %). e) Diversification – index certificates offer a broad diversification, as an index might, for instance, contain hundreds of different stocks. f) Liquidity – index certificates are very liquid products. An investor can always buy or sell index certificates as their price is continuously quoted.

Despite the multitude of advantages, there are several risks connected to index certificates. First of all, because the price of the certificate is based on the evolution of the index, there is always the risk that, once an index is not going to give the expected positive results, the price of the certificate will decrease. The evolution of the index is highly correlated to the economic environment. Crucial to mention is the currency risk. Owning a certificate issued in a foreign currency, an investor is exposed to deviations in his

43 TUCHMAN, Mitch, 2013. What is an index fund? Investing basics. Forbes [online]. Available at: http://www.forbes.com/sites/mitchelltuchman/2013/07/12/what-is-an-index-fund-investing-basics/ [Accessed 28 February 2014]. 35

profits due to possible currency changes. However, grace to Quanto certificates, which are certificates insured against exchange rate deviation, this problem vanishes.

Another thing that can influence the change in price of a certificate is the rating of the issuer. The rating downgrade has an immediate impact on liquidity, thus making the certificate less attractive and valuable. The issuer itself is also representing a risk, as it can encount financial difficulties that may not allow him to meet his obligations. There is also a spread risk, which underlines the differences in the ask and bid price of a certificate. An investor is also exposed to the mispricing risk, when the ask price is higher or the bid price is lower. An important risk to take in account is the maturity risk. The value of the certificate is going to be paid to its holder on the established maturity date, not in the day a certificate reaches a desirable price. Last but not least, there are certain subtle risks concerning taxation and legislation.44

In the final part of this subchapter, I would like to briefly mention about the costs of buying, holding and selling of index certificates. The table below summarizes the main points.

Table 4: Index certificates’ costs

Situation Costs Buying costs - Spread - Bank comission - Brokers commission Holding costs - For certain certificates, the issuer charges annual management fees (1-2 %) - Spread Selling before maturity costs - Bank comission - Brokers commission Maturity costs - Sometimes, the issuer charges fixed fees (e.g. 10 Euro) Source: Author, based Graph 17 from SVOBODA, Martin. Indexové investice. Brno: Dimension a.s., 2001. 274 p. ISBN 80- 238-7634-1, p.92.

4.3.3 Index products

4.3.3.1 Exchange-traded funds Exchange-traded funds or ETFs are funds designed to track indices, but are traded like stocks. Their aim is not to outperform the market, but to replicate it as close as possible. Buying shares of an ETF means buying a basket of shares included in the index that are traded as a single stock. These stocks can be bought and sold throughout the day, thus giving ETFs an incredible good liquidity. Moreover, due to the fact that they are based on an index, they offer a wide diversification for investors. As ETFs imply the attractive concept of trading a basket of shares, their trading volume is bigger compared to the trading

44 SVOBODA, Martin. Indevové investice. Brno: Dimension a.s., 2001. 274 p. ISBN 80-238-7634-1, p.65-90. 36

volume of individual shares. ETF shares can be short selled, bought on margin or held for a longer period.45

Exchange-traded funds are one of the index products that has been very popular both among individual and institutional investors. Since their introduction in 1992/1993 in the United States, ETF market has been growing worldwide. The reasons why investors prefer ETFs are the low costs and tax efficiency. These advantages stem from ETFs passive strategy which does not try to beat the market. Besides, investors like ETFs resemblance to stocks that they are accustomed with and know how to trade and monitor them.46 Graph 4 proves both the world increase of the ETFs number as well as the augmentation of the assets under management.

Graph 4: Worldwide ETF Growth

* As of March 2013 Source: Deutsche Bank AG, , retrieved on 28.02.2014

4.3.3.2 Index derivatives In spite of having their origins in the United States, index based derivatives are nowadays used all over the world. They have become a good, liquid and efficient tool for investors. Index futures, index swaps and index options are some examples of index-based derivatives. The first index futures appeared in 1982 the United States, where Kansas City Board of Trade offered futures contracts on their index (called Value

45 What are ETFs. Nasdaq [online]. Available at: http://www.nasdaq.com/investing/etfs/what-are-ETFs.aspx [Accessed 21 February 2014]. 46 SCHOENFELD A., Steven. Active Index investing, maximizing portfolio performance and minimizing risk through global index strategies. Hoboken, New Jersey: John Wiley and Sons, Inc., 2004. 688 p. ISBN 0-471-25707-9, pp. 41-42 and p. 515. 37

Line Index). Stock index options have also seen the light in 1980s, being actively traded on various stock exchanges in the United States.47

Index futures Index futures are simply described as futures contracts on a stock index. Futures contracts are traded daily on stock exchanges, thing that makes them deeply liquid. This contributes to the reduction of transaction costs for entry and exit. The most liquid equity futures contracts in the world are the S&P 500 futures. Generally, the interest in futures enhance in uncertain times, such as geopolitical or economic events, when investors try to reduce their market exposure.48

Index swaps An equity index swap is a „contract between two counter parties to exchange an interest payment for the return of an index at some future date“.49 The dealer (financial institution) who sells the swap pays to the customer (tipically institutional investor) the index return. The customer instead pays the dealer an interest rate. Usually this interest rate equals the yields of the annualized London Interbank Offered Rate (LIBOR) with a plus/minus spread added. Swaps are not traded on a stock exchange. That makes them less liquid compared to other exchange traded vehicles.50

Index options There are two types of index options: „a call, which gives the right to buy an index; and a put, which gives the right to sell an index“.51 They have an expiration date, where an option can be exercised and an exercise price. Index options can be either listed on a stock exchange or sold over-the-counter (OTC options). These two trading possibilities make index options more liquid than for instance futures, which are not traded OTC, or swaps which are not traded on a stock exchange. Another interesting feature of index options similar to index swaps is their high anonimity when traded OTC.52

47 SCHOENFELD A., Steven. Active Index investing, maximizing portfolio performance and minimizing risk through global index strategies. Hoboken, New Jersey: John Wiley and Sons, Inc., 2004. 688 p. ISBN 0-471-25707-9, p. 267. 48 SCHOENFELD A., Steven. Active Index investing, maximizing portfolio performance and minimizing risk through global index strategies. Hoboken, New Jersey: John Wiley and Sons, Inc., 2004. 688 p. ISBN 0-471-25707-9, p. 510. 49 SCHOENFELD A., Steven. Active Index investing, maximizing portfolio performance and minimizing risk through global index strategies. Hoboken, New Jersey: John Wiley and Sons, Inc., 2004. 688 p. ISBN 0-471-25707-9, p. 522. 50 SCHOENFELD A., Steven. Active Index investing, maximizing portfolio performance and minimizing risk through global index strategies. Hoboken, New Jersey: John Wiley and Sons, Inc., 2004. 688 p. ISBN 0-471-25707-9, pp. 522-523. 51 SCHOENFELD A., Steven. Active Index investing, maximizing portfolio performance and minimizing risk through global index strategies. Hoboken, New Jersey: John Wiley and Sons, Inc., 2004. 688 p. ISBN 0-471-25707-9, p. 523. 52 SCHOENFELD A., Steven. Active Index investing, maximizing portfolio performance and minimizing risk through global index strategies. Hoboken, New Jersey: John Wiley and Sons, Inc., 2004. 688 p. ISBN 0-471-25707-9, pp. 523-527.

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4.3.3.3 Choosing among index products Several factors influence the decision of an investor who chooses among index products. Investment strategy, time horizon, taxes, limitations and required authorizations, anonimity, transaction costs are just few of them. For example, if the investment horizon is medium to short, it is recommendable to use futures instead of ETFs. Futures contracts are more liquid and the comissions charged are lower. A quite delicate factor is the specific requirements and legal authorization to buy a certain index product or to enter a market. For instance, both ETFs and futures contracts provide investors the opportunity to access restricted markets where direct stock investment is limited.

In spite of the fact that all the products described a few paragraphs above are index products, not all of them can be used on whatever index. Futures are available on a small number of indices, the majority of them being in the United States. ETFs are less limited than futures, but still not all indices can be used. Contrariwise, swaps and OTC options are given the freedom to choose whatever index as underlying.

If talking about a sensitive criteria as the anonimity of an investor, we have seen that index futures, ETFs and listed index options do not meet it due to the fact that they are traded on the exchange where there are certain requirements. On the other part, index swaps and OTC index options offer a high degree of confidentiality to investors. Anonimity is not necessarily the best option, as the price of the products that are not publicly traded is not always available and comparable and investors might face problems because of lack of information.53

The variety of index products available on the market gives investors enough products to choose from. It is a matter of interests and possibilities that helps in deciding. The table below presents a full comparison of features between the index products previously described.

53 SCHOENFELD A., Steven. Active Index investing, maximizing portfolio performance and minimizing risk through global index strategies. Hoboken, New Jersey: John Wiley and Sons, Inc., 2004. 688 p. ISBN 0-471-25707-9, pp. 529-533. 39

Table 5: Comparison of features of Index Products Futures ETFs Swaps Options Flexibility Underlying indexes About 20 in the United More than 100 in the Any index About 15 for listed ; States; much fewer in United States; more any for OTC non-U.S. markets than futures in the non- U.S. markets Leverage Greater than stocks Equal to stocks Greater than stocks Greater than stocks Anonimity Limited Limited High Limited for listed; high for OTC Ease of use Regulatory CFTC registration or Tipically same as for Limited to eligible Accredited investor for requirements „no action“ for non- stocks; some fund contract participants OTC U.S. products limits Daily mark-to-market Yes No No Limited to selling uncovered options Transaction costs Entry/exit costs Lower than stocks Lower or equal to Lower or equal to Higher than stocks stocks stocks Holding costs Interest rates Management fee Funding rate Option time decay may embedded in nearby need to roll into next contract price + contract calendar spread price Trading efficiency Liquidity Higher than stocks Higher than or equal to Lower than stocks Lower than stocks stocks Capital commitement Limited Yes Yes Limited for listed; high for OTC Shorting No uptick, no borrow No uptick, borrow-like Depends on underlyer n/a stock Minimum size About $25,000 and up No minimum Varies No minimum Tracking Sources of Nearby mispricing + Premium/discount to None Based on strike and performance difference calendar spread NA or market maker term of option mispricing spread Dividends Forecasts included in Paid quaterly Included in capital Forecasts included in price returns price Source: SCHOENFELD A., Steven. Active Index investing, maximizing portfolio performance and minimizing risk through global index strategies. Hoboken, New Jersey: John Wiley and Sons, Inc., 2004. 688 p. ISBN 0-471-25707-9, pp. 530-531.

4.4 Nikkei 225 and TOPIX investing Grace to its popularity, Nikkei 225 is the Japanese index that is most commonly used in international investment products. This does not mean that there are no products on TOPIX, however, I have to admit, that while searching for investments products, I found many more investment opportunities on Nikkei than on TOPIX. For instance, from Picture 1 and Table 6 we can deduce that Nikkei investment products are not only traded in Japan, but also overseas. On the other hand, TSE does not provide any official information about the licensed exchanges and ETF providers of TOPIX. What I could find on TSE

40

website are TOPIX listed ETFs at the moment, provided by Daiwa Asset Management, Nomura Asset Management, Nikko Asset Management and Mitsubishi UFJ Asset Management.54 Not only Japanese, but also European financial institutions have ETFs on TOPIX. For example, Commerzbank AG manages one of them, called ComStage TOPIX UCITS ETF.55

Table 6: Nikkei Licenced Exchanges and ETF Providers

Exchanges ETF Providers Singapore Exchange Limited Nomura Asset Management Osaka Securities Exchange Daiwa Asset Management CME Group Nikko Asset Management BlackRock Tokyo Stock Exchange Commerzbank Tokyo Financial Exchange Mitsubishi UFJ Asset Management Credit Suisse Simplex Asset Management Precidian Investments Deutsche Bank Source: Author, based on data provided by Nikkei Indexes, , retrieved on 06.04.2014

Picture 1: Nikkei Licencees

Source: Nikkei Indexes, , retrieved on 06.04.2014

54 Listed ETFs. Tokyo Stock Exchange [online]. Available at: http://www.tse.or.jp/english/rules/etfs/list/ [Accessed 9 April 2014]. 55 Global ETFs/Commerzbank AG. Trustnet offshore [online]. Available at: http: http://www.trustnetoffshore.com/Factsheets/Factsheet.aspx?fundCode=HZFV9&univ=E [Accessed 9 April 2014].

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4.5 Index investing comparison For the practical part of this chapter, I have decided to focus my attention on Index Certificates and ETFs that have as underlying Nikkei 225 and TOPIX. I have selected for each index two certificates. These certificates are issued by two European banks, Deutsche Bank AG and Commerzbank AG.

Index Certificates Table 7: Nikkei and TOPIX certificate comparison Certificate name/ Nikkei 225 X-pert TOPIX Index Unlimited Index Unlimited Index criteria Certificate X-pert Certificate Certificate on Certificate on Nikkei 225 TOPIX

Issuer name Deutsche Bank Deutsche Bank Commerzbank AG Commerzbank AG AG AG Product type X-pert Certificates X-pert Certificates Unlimited Index Unlimited Index Certificate Certificate Maturity Open End Open End Open End Open End Current price* Bid/Ask (EUR) 10.420/ 10.430 8.410/ 8.430 14.71/ 14.74 11.89/ 11.91 Quanto No No Yes Yes Ratio 0.10 1.00 1000:1 100:1 Issue date 13/02/2001 13/02/2001 18/09/2000 18/09/2000 Performance 1 year 0.29 % -2.77 % unavailable unavailable Management fees none none none none VaR56 (EUR, 250 days) 4070.59 3787.26 4158.22 3906.01 * As of April 7, 2014 Source: Author, based on data provided by Deutsche Bank AG and Commerzbank, , , , , retrieved on 07.04.2014

Deutsche Bank offers Nikkei 225 and TOPIX X-pert certificates that do not have a fixed maturity date. They were issued the same day and they are not insured against currency risk. As seen from the table above, TOPIX certificates are cheaper and their Value at Risk is lower, appearing at first sight more attractive. However, their negative performance of -2.77 % during last year compared to the positive performance of those of his rival makes me recommend Nikkei 225 X-pert Certificate.

56 The VaR (Value at Risk) is the loss of an investment of 10.000 EUR in this certificate which will not be exceeded with 99 percent probability during the given period of time. 42

Another option that has been viewed is the Quanto certificates on Nikkei and TOPIX, issued by Commerzbank. We can notice the same tendency of a higher price of Nikkei compared to TOPIX certificates. Similarly to Deutsche Bank Certificates, the Value of Risk is also working in favor of TOPIX. However, despite the absence of data on one year performance, there is an important remark to be made. If you look on Commerzbank website at the performance of these certificates, you can notice that before the crisis, both certificates were traded at almost the same prices (between 16-18 EUR). However, after the crisis, Nikkei certificate has managed to recover far better than TOPIX certificate. An eloquent proof of the post-crisis performance is the actual price of Nikkei certificate. Looking some chapters back, we have seen and commented on the over-performance of Nikkei compared to TOPIX since 2009. As certificates track indices, this result on the price and evolution of index certificates has been expected. Concluding, between Commerzbank’s Quanto certificates, I think the certificate on Nikkei is a better choice.

ETFs For the second part of this subchapter, ETF investment is going to be analyzed. For a fair comparison, I have chosen for each index an ETF that is provided by the same management company called Nomura Asset Management Co., Ltd.

Table 8: Nikkei and TOPIX Exchange-Traded Funds comparison

Fund name Nikkei 225 Exchange-Traded Fund TOPIX Exchange-Traded fund Underlying index Nikkei 225 TOPIX Management company Nomura Asset Management Nomura Asset Management Dividend payment date 8 July of each year 10 July of each year Trading unit 1 unit 10 units Total expense ratio 0.24 % 0.11 % - With in tax 0.252 % 0.1155 % ETF net assets 1 854 395 (mil JPY) 1 517 679 (mil JPY) Shares outstanding 122 465 thous.units 1 227 667 thous.units Market price 15 150 JPY 1 234 JPY Gross dividend paid 187 JPY 19.4 JPY 12 months dividend yield 1.23 % 1.57 % Investment amount per lot 15 150 JPY 12 340 JPY Return on investment (past 1 year) + 33.63 % + 26.56 % Return on investment (past 5 years) + 112.48 % + 76.03 % Volatility (90D) 23.3 % 20.9 % Source: Author, based on data provided by Tokyo Stock Exchange Nikkei and TOPIX ETF pamphlets, , , retrieved on 07.04.2014

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After studying the updated prospectus of each ETF, I have noticed that except the underlying index, there are no differences in the investment policy, investment restrictions, distribution policy, risk management system or tax treatment. Major differences between Nikkei 225 Exchange-Traded Fund and TOPIX Exchange-Traded Fund are summarized in the table above.

TOPIX ETF is the largest ETF in Japan.57 As you can see, there are some differences in the trading unit, Nikkei having trading unit one, while TOPIX ten. This thing is also reflected in the market price of the ETF, as the market price of Nikkei is more than twelve times higher than TOPIX’s. However, if you look at the investment amount per lot, you will see where the balance comes between these two ETFs. Personally, I regard TOPIX’s the smaller investment amount per lot as an advantage, which gives the general investment public a cheaper way to buy ETFs. I would recommend an investor to rather invest in TOPIX ETFs than in Nikkei’s. It is true that Nikkei 225 ETF generates better returns on investment than TOPIX, but there are several disadvantages that work in TOPIX’s favor. First of all, Nikkei’s ETF total expense ratio which either with or without tax, is more than twice higher than TOPIX’s. Second, the dividend yield is slightly better in case of TOPIX. Thirdly, TOPIX’s volatility is a few percent less than Nikkei’s ETF volatility.

57 TOPIX and Nikkei225. Tokyo Stock Exchange [online]. Available at: http://www.tse.or.jp/english/market/topix/comparison.html [Accessed 6 April 2014]. 44

Conclusion

Stock indices represent a primordial instrument for financial markets. In this thesis we have seen that during the last century the world of indices has considerably evolved. Nowadays, indices are not only used to describe the situation on the stock market, but also serve as a basis for a multitude of investment products. We have also seen that there are several possibilities to build an index and give weight to its components. There have been underlined special adjustment techniques and the free-float methodology. Furthermore, this thesis is not limited to index construction only, but also has tried to show one of the practical aspects of index usage. Hence, the last chapter was aimed at index investing where you could also see why index investing became so popular in a short time. Even though index investing is considered to be part of passive investment strategy, it has been proved that it can be considered active as well. Lastly, the thesis incorporated a short description and comparison of index investment opportunities.

For the practical side, two Japanese rivals have been described, TOPIX and Nikkei 225. We have seen how different their construction methodology is. My opinion is that among these two indices, TOPIX’s way of construction is better. I think that a value weighted index is more representative than a price weighted index. Besides, the free-float weight technique implemented by TOPIX is a modern tool that improves index calculation and is useful for potential investors and index funds. Moreover, I definitively see constituents’ selection at TOPIX as a much more transparent process than in case of Nikkei 225. Finally, I think that grace to its larger number of constituents TOPIX is much better diversified and has a bigger capacity to reflect Japanese economy.

Except the index construction aspect, this thesis was analyzing possible investment products related to Nikkei 225 and TOPIX. You could see a comparison between TOPIX and Nikkei 225 index certificates as well as these indices’ two ETFs. After comparing these investment opportunities, I am not categorical about one single index. This comparison has proven that in some cases Nikkei’s products can generate better returns than TOPIX’s and vice versa.

The goal of this thesis was to analyze the chosen Japanese indices of financial and capital markets, to evaluate methods of their construction and formulate recommendations. I consider this goal accomplished because both Nikkei 225 and TOPIX methods of construction were described in details and given an evaluation. Furthermore, there has been provided a comparison of index investment products on these indices and have been given conclusive opinions about which investment product to choose.

45

References

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[2] FERRI A., Richard. The power of passive investing: more wealth with less work. Hoboken, New Jersey: John Wiley and Sons, Inc., 2011. 264 p. ISBN 978-0-470-59220-5.

[3] HEBNER T., Mark. Index Funds: The 12-Step Recovery Program for Active Investors. Irvin, California: IFA Publishing, Inc., 2007. 394 p. ISBN 0-9768023-0-9.

[4] SCHOENFELD A., Steven. Active Index investing, maximizing portfolio performance and minimizing risk through global index strategies. Hoboken, New Jersey: John Wiley and Sons, Inc., 2004. 688 p. ISBN 0-471-25707-9.

[5] SVOBODA, Martin. Indexové investice. Brno: Dimension a.s., 2001. 274 p. ISBN 80-238-7634-1.

[6] VESELA, Jitka. Investování na kapitálových trzích. Prague: ASPI, 2007. 704 p. ISBN 978-80-7357- 297-6.

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[9] BOUSSER, Thimothee, 2013. A closer look at TOPIX. The asset [online]. Available at: http://mobile.theasset.com/inside.php?tid=24654 [Accessed 6 April 2014].

[10] ENDO, Nobuya, 2013. Japanese benchmarks The Nikkei and the TOPIX Face-off. [pdf] State Street Global Advisors. Available at: http://www.ssga.com/library/povw/516936_Japanese_Benchmark_The_Nikkei_and_the_TOPIX_Face_Of fCCRI1362694345.pdf [Accessed 20 February 2014].

[11] Global ETFs/Commerzbank AG. Trustnet offshore [online]. Available at: http: http://www.trustnetoffshore.com/Factsheets/Factsheet.aspx?fundCode=HZFV9&univ=E [Accessed 9 April 2014].

[12] Growth of ETF market. Deutsche Bank AG [online]. Available at: http://www.etf.db.com/ZAF/ENG/ETF-Knowledge/Growth-of-ETF-market [Accessed 28 February 2014].

[13] Historical data. Nikkei Indexes [online]. Available at: http://indexes.nikkei.co.jp/en/nkave/archives/data [Accessed 20 March 2014].

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[14] History of TOPIX. Tokyo Stock Exchange [online]. Available at: http://www.tse.or.jp/english/market/topix/history/index.html [Accessed 20 March 2014].

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[17] KENNEDY, Mark, 2014. Different types of weighted indexes. Exchange traded funds [online]. Available at: http://etf.about.com/od/etfbasics/a/Different-Types-Of-Weighted-Indexes.htm [Accessed 22 February 2014].

[18] Listed ETFs. Tokyo Stock Exchange [online]. Available at: http://www.tse.or.jp/english/rules/etfs/list/ [Accessed 9 April 2014].

[19] Nikkei 225. Google finance [online]. Available at: https://www.google.com/finance?q=INDEXNIKKEI%3ANI225&ei=i9lGU5DELcGkwAOOxgE [Accessed 10 April 2014].

[20] Nikkei Indexes. Nikkei Indexes [online]. Available at: http://indexes.nikkei.co.jp/en/nkave/index [Accessed 30 March 2014].

[21] Nikkei Indexes, 2011. Nikkei Stock Average Index Guidebook. [pdf] Tokyo: Nikkei Inc. Available at: http://indexes.nikkei.co.jp/nkave/archives/file/nikkei_stock_average_guidebook_en.pdf [Accessed 20 March 2014].

[22] Nikkei Indexes, 2011. Nikkei Stock Average Par Value. [pdf] Tokyo: Nikkei Inc. Available at: http://indexes.nikkei.co.jp/nkave/archives/file/nikkei_stock_average_par_value_en.pdf [Accessed 20 March 2014].

[23] Nikkei 225 X-pert Certificate. Deutsche Bank AG [online]. Available at: https://www.xmarkets.db.com/DE/ENG/Product_Detail/DE0007093387 [Accessed 7 April 2014].

[24] SAUTER, Gus, 2002. Index Rex. Journal of indexes [online]. Available at: http://www.etf.com/publications/journalofindexes/joi-articles/1411-index-rex.html?fullart=1&start=6 [Accessed 21 February 2014].

[25] Tokyo Stock Exchange, 2014. JPX-Nikkei Index 400 Factsheet. [pdf] Tokyo: Tokyo Stock Exchange. Available at: http://www.tse.or.jp/english/market/topix/b7gje6000001ns00-att/b7gje6000001rsua.pdf [Accessed 6 April 2014].

[26] Tokyo Stock Exchange, 2014. Nikkei 225 Exchange Traded Fund. [pdf] Tokyo: Tokyo Stock Exchange. Available at: http://www.tse.or.jp/english/rules/etfs/list/pamphlet/1321-e.pdf [Accessed 7 April 2014].

[27] Tokyo Stock Exchange, 2012. Tokyo Stock Exchange Index Guidebook. [pdf] Tokyo: Tokyo Stock Exchange. Available at: http://www.tse.or.jp/english/market/topix/b7gje60000003v3u- att/b7gje60000006cm3.pdf [Accessed 20 December 2013].

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[28] Tokyo Stock Exchange, 2014. TOPIX Exchange Traded Fund. [pdf] Tokyo: Tokyo Stock Exchange. Available at: http://www.tse.or.jp/english/rules/etfs/list/pamphlet/1306-e.pdf [Accessed 7 April 2014].

[29] Tokyo Stock Exchange, 2005. TOPIX moves to Free-Float. [pdf] Tokyo: Tokyo Stock Exchange. Available at: http://www.tse.or.jp/english/market/topix/b7gje60000003v3u-att/pamphlet-e.pdf [Accessed 20 March 2014].

[30] TOPIX and Nikkei225. Tokyo Stock Exchange [online]. Available at: http://www.tse.or.jp/english/market/topix/comparison.html [Accessed 20 March 2014].

[31] TOPIX Index X-pert Certificate. Deutsche Bank AG [online]. Available at: https://www.xmarkets.db.com/DE/ENG/Product_Detail/DE0007093379 [Accessed 7 April 2014].

[32] TSE first section issues. Google finance [online]. Available at: https://www.google.com/finance?q=INDEXTOPIX%3ATOPIX&ei=htlGU6DvD8aDwAPFJA [Accessed 10 April 2014].

[33] TUCHMAN, Mitch, 2013. What is an index fund? Investing basics. Forbes [online]. Available at: http://www.forbes.com/sites/mitchelltuchman/2013/07/12/what-is-an-index-fund-investing-basics/ [Accessed 28 February 2014].

[34] Unlimited Index Certificate on Nikkei 225. Commerzbank [online]. Available at: http://www2.warrants.commerzbank.com/Products/ProductDetails.aspx?rp=None&rps=None&c=1077594 &p=139666724&pc=81&dm=NoHeaders&ip=1&pm=Full [Accessed 7 April 2014].

[35] Unlimited Index Certificate on TOPIX. Commerzbank [online]. Available at: http://www2.warrants.commerzbank.com/Products/ProductDetails.aspx?rp=None&rps=None&c=1077594 &p=139666716&pc=81&dm=NoHeaders&ip=1&pm=Full [Accessed 7 April 2014].

[36] Value weighted stock index: construction, problems and adjustments. Macroption [online]. Available at: http://www.macroption.com/value-weighted-stock-index-construction-problems-adjustments/ [Accessed 22 February 2014].

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List of graphs Graph 1: Nikkei Stock Average’s evolution since creation 21 Graph 2: TOPIX’s evolution since creation 23 Graph 3: Nikkei 225’s relative performance versus TOPIX (2005-2014) 27 Graph 4: Worldwide ETF Growth 37

List of tables Table 1: Sector allocation comparison 25 Table 2: Comparison of Nikkei 225 and TOPIX Summary 28 Table 3: The difference between Active and Index Fund investment strategies 34 Table 4: Index certificates’ costs 36 Table 5: Comparison of Features of Index Products 40 Table 6: Nikkei Licenced Exchanges and ETF Providers 41 Table 7: Nikkei and TOPIX certificate comparison 42 Table 8: Nikkei and TOPIX Exchange-Traded Funds comparison 43

List of pictures Picture 1: Nikkei Licencees 41

49

List of annexes Annex A Indices calculated by TSE Annex B Indices calculated by Nikkei Inc. Annex C Current Nikkei Stock Average components by sector Annex D Current TOPIX sector classification

50

Annex A

Indices calculated by TSE

Source: Tokyo Stock Exchange, , retrieved on 20.03.2014

51

Annex B

Indices calculated by Nikkei Inc. 1) Nikkei Stock Average & Derived Indexes - Nikkei Stock Average - Total Return Index a) Nikkei 225 Total Return Index - Nikkei Stock Average Strategy Index Series a) Nikkei 225 Covered Call Index b) Nikkei 225 Risk Control Index c) Nikkei 225 Leveraged Index d) Nikkei 225 Inverse Index - Volatility Index a) Nikkei Stock Average Volatility Index b) Nikkei 225 VI Futures Index - Dividend Point Index a) Nikkei Stock Average Dividend Point Index 2) Other Stock Indexes - JPX-Nikkei Index 400 - Theme Index a) Nikkei China Related Stock 50 - Benchmark Index a) Nikkei Stock Index 300 b) Nikkei 500 Stock Average c) Nikkei JAPAN 1000 d) Nikkei JASDAQ Stock Average e) Nikkei All Stock Index 3) Bond Index - Nikkei JGB Index - Nikkei Bond Index 4) Commodity Index - Nikkei Commodity Index - Nikkei Commodities Futures Index - Nikkei-TOCOM Commodity Index - Nikkei-TOCOM Leveraged Index

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- Nikkei-TOCOM Inverse Index 5) Other Index - Nikkei Currency Index - Nikkei Business Index - Nikkei Business Climate index

Source: Nikkei Indexes, , retrieved on 20.03.2014

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Annex C

Current Nikkei Stock Average components by sector

Sector Total number of companies Subsector Number of in the sector companies Pharmaceuticals 8 Electric machinery 29 Technology 57 Automobiles & Auto parts 9 Precision Instruments 5 Communications 6 Banking 11 Financials 21 Securities 3 Other financial services 1 Insurance 6 Consumer goods Fishery 2 28 Retail 8 Foods 11 Services 7 Mining 1 Pulp & Paper 3 Petroleum 2 Materials 64 Glass & Ceramics 9 Nonferrous metals 12 Textiles & Apparel 5 Chemicals 18 Rubber 2 Steel 5 Trading companies 7 Construction 8 Capital goods/ Shipbuilding 2 Others 35 Other manufacturing 3 Machinery 16 Transport equipment 0 Real estate 6 Railway & bus 8 Transportation Marine transport 3 and utilities 20 Warehousing 1 Gas 2 Land transport 2 Air transport 1 Electric power 3 Source: Author, based on data provided by Nikkei Indexes, , retrieved on 20.03.2014

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Annex D

Current TOPIX sector classification

Category Constituents (sectors) Foods Fishery, Agriculture and Forestry; Foods Energy resources Mining; Oil and coal products Construction and materials Construction; Metal products; Glass and ceramics products Raw materials and chemicals Textiles and apparels; Pulp and paper; Chemicals Pharmaceutical Pharmaceutical Automobiles and transportation Rubber products; Transportation equipment equipment Steel and nonferrous metals Iron and steel; Nonferrous metals Machinery Machinery Electric appliances and precision Electric appliances; Precision instruments instruments IT and services, others Other products; Information and communication; Services Electric power and gas Electric power and gas Transportation and logistics Land transportation; Marine transportation; Air transportation, Warehousing and harbor transportation service Commercial and wholesale trade Wholesale trade Retail trade Retail trade Banks Banks Financials (ex banks) Securities and commodities futures; Insurance; Other financial business Real estate Real estate Source: Author, based on data provided by Tokyo Stock Exchange, , retrieved on 20.03.2014

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