Japan looks to Hong Kong Tracker Fund for cross-shareholding solution

Yanagisawa is said by market players to be discussing the idea with Nomura Securities, which would sponsor the product. The ETF would track the Tokyo Stock Exchange’s TOPIX index, which is the major benchmark for Japanese institutional investors.

The FSA earlier this spring scrapped the remaining legal hurdles for introducing ETF's. Both State Street and Barclays Global Investors are feverishly working to introduce ETF's to Japan this year. BGI hopes to launch an ETF on the Tokyo Stock Exchange using the S&P/TOPIX 150 index, which was introduced last year, while State Street, which is the manager of the $3.9 billion Tracker Fund, has not yet publicized details about its expected product.

ETF's are the hottest product now in the US. ETF volumes on the American Stock Exchange grew 11% just in April. Despite the fact that markets have been declining, there are now 83 ETF's listed in the US, with an aggregate $80 billion of assets under management says Murali Ranaswami, managing director and global head of equity derivatives and quantitative research at Lehman Brothers in New York.

ETF's are open-ended funds listed on an exchange that trade like securities, are passively managed against an index, and use in-kind contributions and redemptions. They are popular with institutional and retail investors, as well as market makers and hedge funds.

An ETF is a creative way for the Japanese government to manage the problem of cross-holdings among keiretsu. The problem of cross-holdings will enter the limelight beginning next week when MSCI puts its global indices on a free-float footing. Analysts estimate up to $7 billion could flee Japan over the next year because of the low free float there, due to extensive crossholdings. Moreover, corporate restructuring and the introduction of mark-to-market accounting in April are forcing many companies to unwind such holdings. The net impact is to dampen Japanese equities prices, which in turn continues to hurt both banks’ and corporates’ balance sheets.

But ETF's only work in the right regulatory environment, and many ETF experts are skeptical about the FSA’s plan, although they remain unaware of its details. The main impediment is the size of TOPIX, which has 1400 constituent stocks. Contributions and redemptions to ETF's are made in-kind, meaning to buy a unit of an ETF, an investor does not use cash, but provides the sponsor with a basket of securities mirroring the index. In Hong Kong this is easy: the Hang Seng Index has only 33 constituent stocks. In the US, the two most popular ETF's, with a combined AUM of $56 billion, are the S&P SPDR tracking the S&P500, and QQQ tracking the Nasdaq 100. Even 500 stocks is a tall order, but possible in the highly liquid US market.

Japan’s equity markets are not as large as America’s, and ETF practitioners wonder how Nomura or any other provider will be able to efficiently manage contributions and redemptions involving 1400 stocks.

The ability of brokers to create and redeem these baskets in a quick and inexpensive way is the key to a successful ETF, says Agustin Fleites, principal of investment management at State Street Global Advisors in Boston.

If the process becomes complicated for brokers to hedge in the event they can’t fulfil an order, spreads on the ETF will widen. The point to an ETF is that its value should closely mirror that of the underlying basket, and any discrepancies are eliminated by market arbitrageurs. If this mechanism breaks down, investors won’t get fair pricing and the ETF will be a flop. It is questionable how ready Japan’s markets are for the necessary futures market to make ETF arbitraging work.