Last month, the formulators of the Nikkei 225 attempted to update the index in order to reflect the growth of the high-tech sector in the Japanese economy. While editors at the Nihon Keizai newspaper were operating on the belief that the index had become increasingly outdated, the changes made to the index on April 24th were ill-timed and hasty, and have inflicted significant damage on index investors. To make matters worse, the changes involved a big increase in the technology exposure of the index, just in time for a big decline in technology stocks worldwide.
The Nikkei 225 in Japan is similar in many ways to the Dow Jones Industrial Average in the U.S. Both indexes are managed by a newspaper company, both are share-price weighted rather than market-value weighted, and both are widely believed to represent “the market’s” performance in their countries.
That assumption may be less applicable to the Nikkei now. The Nihon Keizai editors made changes amounting to over 40% of the index’s value, and implemented the changes over the course of just one week. They removed 30 mostly small companies in the chemicals, metals, and materials industries, and added 30 larger companies oriented towards technology, communications, and banking. After the changes, six of the seven highest-weighted stocks in the index were new additions.
Investors who were indexing the Nikkei 225 (and the number is substantial in Japan) were forced to do the following: 1) sell 100% of the 30 stocks being deleted; 2) because the value of the deleted shares represented less than a tenth of the value of the incoming shares, partially sell all the remaining shares in the index to raise cash; and 3) buy the 30 newly-added shares, now representing 43% of the Nikkei’s value.
These changes naturally created lots of trading and volatility, so arbitrageurs had a field day while the index sank. Immediately after the announcement was made on April 14th, stocks joining the index rallied substantially, making them more expensive before entering. Stocks remaining on the index at lower weights fell moderately. Stocks being removed from the index altogether fell substantially during their last week in the index. On April 24th, after the new highly valued technology and communications stocks actually joined the index, arbitrageurs took their profits and the stocks immediately began sinking. In short, each aspect of the change did damage to the Nikkei.
And damage is the operative word. On April 14th, the day the changes were announced, the Nikkei traded at 20435. On May 24th, the Nikkei stood at 16044, over 21% lower. Paribas Japan recently published an analysis attributing about half of this decline to the mechanics of the index changes.
In my opinion, the Nikkei 225 is now bizarrely top-heavy with technology companies, a feature exacerbated by its archaic price-weighted construction technique. On May 24th, the top stock in the Nikkei was the virtually unknown company Advantest, which makes computer chip testers. Advantest possesses less than a tenth the market capitalization of Japan’s largest company, the communications giant NTT DoCoMo, yet Advantest is given a 6.68% weight in the index, while NTT DoCoMo has a 0.82% weight. It doesn’t make any sense, but in this index, small companies with a large stock price per share can dominate much larger companies with a smaller stock price per share.
Considering all of this, it may be time for investors and the media to ditch the Nikkei 225 index as the measure of the Japanese stock market. The Nikkei seems to be managed by methodologically-challenged amateurs who help arbitrageurs more than they do investors. I believe both Morgan Stanley and Topix construct far more useful indexes of the Japanese market.
