Only 17 of 215 ETFs listed in Japan invest in narrow themes © AFP via Getty Images

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While thematic ETFs are now very much in vogue in most major global investment markets, they remain a rarity in Japan.

There are currently 215 ETFs listed in Japan, only 17 of which are thematic products. In terms of assets, thematic ETFs only account for 0.28 per cent of the total ETF assets in July, according to data from Morningstar Direct.

Nearly 90 per cent of all ETF assets in Japan track either the broad-market Nikkei 225 or Topix indices as of July, Morningstar Direct data show. A third broad-market index, the JPX-Nikkei 400, is gaining traction among local managers, claiming 4.76 per cent of total ETF assets last month.

Yasunori Kasai, Tokyo-based director for data and analytics in Japan at the London Stock Exchange Group, said it would be unfair to say that Japanese investors and managers dislike thematic investing, but the combination of ETF and thematic that sounded “boring” to them.

This article was previously published by Ignites Asia, a title owned by the FT Group.

If investors want to find alpha, they will look to the mutual fund market, he added.

While the thematic ETF space is tiny in Japan, the country is the biggest market for thematic mutual funds outside of the US and Europe, with total assets of $56bn or roughly 7.6 per cent of the entire mutual fund market, according to a report published by Morningstar in May.

The lack of development in Japan’s thematic ETF space stands in sharp contrast with other Asian markets. Fund houses in TaiwanHong Kong and mainland China have rushed to roll out thematic ETFs this year, many of which focus on technology and sustainability, hoping to find a new niche and capture the increasing demand for new thematic strategies.

There are a number of reasons why Japan’s thematic ETF market has not taken off, analysts say. The primary factor is that the handful of large Japanese ETF providers feel little need to innovate because they already scoop up a big chunk of their profits from the annual fees paid by the Bank of Japan in its ongoing ETF buying spree.

The BoJ is the largest owner of Japanese ETFs due to the monetary easing policy first introduced in 2013. Although there is no public disclosure of exactly what percentage of the ETF market is held by the central bank, the estimate is that it could be as high as 85 per cent.

However, the BoJ’s ETF purchasing programme is only one part of the puzzle. Japanese asset managers also face regulatory hurdles to launching innovative, thematic ETFs.

One of the most restrictive measures is a direct order from the Japan Exchange Group that prohibits asset managers from establishing an ETF based on its own index, while launching active ETFs in Japan is also not permitted.

“Regulations require that ETFs created in Japan track third-party indices. This naturally limits the themes an ETF can have and how it must be managed,” Junichiro Ariga, joint global head of ETF business at Japan’s domestic fund house Nikko Asset Management, said.

Jooyoung Yun, chief investment officer at ETF provider Global X Japan, said in addition to the indices restrictions, providers also have to deal with an extremely powerful mutual fund distribution network that is reluctant to sell ETFs due to low commission fees.

The Japanese ETF market also lacks the ideal investor mix for thematic ETFs. While thematic ETFs are usually targeted at retail investors, the Japan ETF market has one of the lowest retail participation rates in the world, with only 2.8 per cent of the market taken up by retail investors by last June, according to the latest data available from the Tokyo Stock Exchange.

However, despite all these potential hurdles, some ETF providers in the market are taking a punt on bringing a host of new thematic ETF strategies to Japan.

This year, Global X Japan has already rolled out a series of seven thematic ETFs featuring themes from video games and animation to ecommerce, in anticipation of increased demand for the strategies in the market.

Japan’s Sumitomo Mitsui Trust Asset Management also launched its first thematic ETF, the SMT Carbon Efficient Index Japan Equity ETF, in late June.

“We have seen that after [the] coronavirus pandemic, the popularity [of] and interest [in] thematic investing is getting higher globally, including Japan,” Global X Japan’s Yun said.

Other factors, including increased usage of online investment and a supportive Financial Services Agency, will also help boost the Japanese thematic ETF market in the long run, Yun said.

“Everything is difficult to start from scratch, but I believe there will be a paradigm-shift time when the energy of change condenses and explodes at some point in the future,” he added.

*Ignites Asia is a news service published by FT Specialist for professionals working in the asset management industry. It covers everything from new product launches to regulations and industry trends. Trials and subscriptions are available at ignitesasia.com.

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