Japan ETFs to surge on institutional demand, fee cuts

Japan’s large but immature exchange-traded funds (ETF) market will enjoy further development in 2017, on the back of rising appetite from local pension and insurance companies and moves by the government to lower fees on other competitor products such as mutual funds.

ETFs in Japan have already enjoyed a boost in volumes due to the Bank of Japan’s (BoJ) aggressive buying spree, as part of its ongoing quantitative easing efforts. It represents $90 billion of the $154 billion ETF market at the end of June and intends to grow its balance sheet by ¥80 trillion ($765 billion) per annum.

The central bank could end up owning close to 6% of Japan’s entire equity market via ETFs on its current buying momentum, said Jesper Koll, chief executive of the Japan business for US ETF specialist Wisdom Tree. To this end, it is buying about ¥1 trillion of real estate investment trusts (Reits) on top of its mandated ¥6 trillion yen of ETFs (doubled from ¥3 trillion in June this year).

While the central bank will remain the dominant player in buying domestic equity ETFs, pension funds and insurance companies look set to step in with large allocations to global ETF strategies.

The Government Pension Investment Fund (GPIF) is already shifting its broad asset allocation by doubling its equity exposure to 25%, and has said it will include ETFs that use smart beta, or indexes that use factors other than market capitalisation, going forward.

However, it hasn't yet implemented the ETF strategy and Koll told AsianInvestor the pension fund's internal team is currently in study-mode. "Year-to-date they have not bought any ETFs, neither local nor global, but they have opened up the whole research area," to track indices and identify the right factors, he noted.

In addition to GPIF, private insurance companies and pension funds are watching these developments with an eye to diversifying their investments, said Koll.

He declined to comment on discussions taking place with GPIF and other pension funds and insurers, but said Wisdom Tree chose to set up its first Asian office in Tokyo (in September 2015) because of this potential.

"Japanese clients are very service-intensive. So it’s not just a question of sending them a couple of spreadsheets with your performance or your methodology; it’s much more labour-intensive," said Koll.

Following GPIF's footsteps

According to Morningstar, Japan accounts for 69% of the regional total of ETF products and saw its assets grow by 71% in the year to June 30.

There are no indications as to the exact extent of the likely shift to ETFs, but Japanese institutions are likely to follow the GPIF's lead. The public pension fund is working to build a 5% allocation to alternatives, equivalent to $50 billion. It has not yet revealed the extent of its planned smart beta ETF exposure, but given its broader portfolio shift to equities it would seem reasonable to expect a similar weighting.  

AsianInvestor was unable to reach GPIF by press time for comment on the progress of its ETF study group.

Matthew Arnold, head of ETF strategy and research for Asia at State Street Global Advisors, said ETFs are quickly becoming institutional investors’ preferred means of beta replication. In anticipation of this, traditional providers have already jumped on the BoJ gravy train, setting up ETF product development teams in Japan.

Global ETF players such as iShares, State Street, Samsung and Wisdom Tree and Chinese fund groups including CSOP and China Asset Management have all moved in. They anticipate Japan's ETF market will expand on the back of rising institutional and retail investor interest. 

The funds have been broadening their product palettes to include smart beta or factor strategies. Wisdom Tree has 29 of its range of over 100 smart beta ETFs registered for sale in Japan.

Beta maxing

Another initiative that could drive growth in ETFs is the Nippon Individual Savings Account (NISA), a tax-free investing programme that forms part of the government's initiative to get retail investors to diversify more of their savings from bank deposits into risk assets.

Currently, Japanese households have an estimated ¥920 trillion ($8.8 trillion) in bank deposits, earning zero interest. And while Koll noted that approximately ¥8 trillion has been raised via retail investors into NISA accounts over the last two years, only 1.1% of that sum is in ETFs.Japan ETFs to be boosted by new regulations.

“I think it’s fair to say if you had a similar type of structure in the US, for example, you would find probably 60% to 70% of the money invested in ETFs,” he said. That's another $50 billion that could potentially flow into the local ETF market.

A key reason why the market for ETFs is still relatively undeveloped is that the fee structures on traditional investment products (mutual funds) range between a hefty 4% and 5%.

"The fee structures in Japan are not at all transparent," said Koll, "The classic distribution model is fully incentivised to sell high fee structures rather than sell cost-efficient vehicles to Mr. and Mrs. Watanabe (or typical Japanese retail investors)."

The Abe administration is cognisant of this and has embarked on a reform programme to make the fee process for funds more transparent, in much the same way as had occurred in the US and Europe.

The first concrete legislative proposal will be in front of Parliament by March next year, said Koll. "It is clear that ETFs will broaden out when this new disclosure regime comes into effect and distribution channels move to a more fee-based model.

"This is going to be a litmus test of Abenomics; can you break through the vested interests of the traditional service providers?"

Some are already predicting the likely winner. Exchange-traded funds will be the dominant fund structure globally by 2030, suggested Deborah Fuhr, managing partner of research house ETFGI.