The impact of the new TOPIX Index ($)
Winner Stays On: the potential risk and opportunities
Recently I was fortunate to have lunch with a successful investor from Japan, and a conversation on the TOPIX reform triggered me to take some time to reflect on it as we close in on Phase 2 of the reform. I’ve been trying to understand what the changes in the inclusion criteria for the TOPIX could mean in the coming years. I now realise it’s worthwhile for Japan investors to think through in terms of the potential risks and opportunities. I figured I’d share some of my notes!
TOPIX is one of the main indices used in Japan (besides the Nikkei 225). The Tokyo Stock Exchange (TSE) estimates the TOPIX has underlying assets of ¥83trn ($550 US billion) through passive instruments, so changes in how it is calculated and thus rebalanced can lead to meaningful volumes for certain stocks.
The TSE governance shakeup has been the talk of the town for Japanese equities for the last 2 years or so. But this was one aspect I felt has been less talked about. This is a multi-year initiative and we’re about to enter “phase 2” of the reorganization of the TOPIX. As it will take some years, I felt it important to consider the implications. NGL, indexes aren’t really my expertise so I’ll try to be purely informative first and add my analysis at the end. I think there are worthwhile risks/opportunities to consider but I also have a serious question - will this even matter?
Today I’ll break it up into 3 simple points:
How the Topix is now (Phase 1)
What’s expected to change (Phase 2)
Thoughts on the potential opportunities and risks (incl. a couple names I like that could benefit)
The Current TOPIX (Phase 1)
Phase 1 started in 2022 around the time we saw the TOPIX change the listing segments. Previously these were TSE 1st Section, TSE 2nd Section, JASDAQ, and TSE Mothers. These were largely reorganized into 3 buckets today which are:
Prime
Standard
Growth
With each segment having different requirements with the Prime being the most stringent. TSE provides a good overview. Here are the requirements for each, as you can see they differ quite a bit:
Separate from that, they changed the TOPIX inclusion criteria, this was ‘Phase 1’:
Place a focus on free float-adjusted market cap (FFMC) calculation that excludes Cross-shareholding (So called Strategic Shareholding)
Phase out constituents with a Free Float Market Cap <¥10bn under this definition
Those that do not meet these requirements will be all phased out of the index (via gradual quarterly weight reduction) from Oct 2022 through Jan 2025
Introduce an upper weight limit of 10%
What is of note here, and in line with what the TSE wants to discourage: they don’t include the Cross-shareholding (unless considered as a 'pure investment’) in the free float “Tradable Shares” calculation thereby discouraging those from having such cross-holdings - if they want to be considered for the TOPIX.
Prior to phase 1 any Prime-listed companies were included no matter the size or liquidity. (Prior to the re-segmentation, all TSE 1st companies were included in the TOPIX). The issue with this is that, while the index aims to function as a barometer of Japan’s overall equity market, this non-stringent approach makes the index include quite a few… 'shitcos’ - and because once you’re in, you were considered to be a lifetime member of the club, there were no incentives for the companies to keep it up. Putting the actual investability (which, I recently found out is not a real word…) into question. The implication here is that you're no longer safe just because you’re Prime listed.
By January 2025 we’re expecting the complete exclusion of constituents with a free-float market cap below ¥10bn and that’ll reduce the number of index constituents from about 2200 to ~1700.
What will change? (Phase 2)
As phase 1 is underway and planned to be completed January 2025 - The TSE will further tighten the the inclusion criteria in the coming years. They’ve added an additional filter with a focus on liquidity, this will be gradually implemented through 2028. From then on there will also be an annual rebalancing policy.
To summarise the main changes in phase 2:
Inclusion into the TOPIX for the top 96% of the cumulative FFMC
For those that are already in the TOPIX exclusion of the bottom 3%
Annual Traded Value* >0.2 to be included in TOPIX >0.14 to avoid exclusion
For new listings, it must be in the top 95% of cumulative FFMC.
By July 2028, the TOPIX will gradually reduce the # of constituents to ~1200
TOPIX will now include stocks from all segments: Prime, Standard, and Growth
Annual Review/rebalance every last business day of October i.e. you can no longer semi-permanently stay on the TOPIX.
Consequently, there will be a reweighting of stocks that remain in the TOPIX after the reform.
Those that no longer meet the cut-off will be gradually reduced in weight from the TOPIX starting from October 2026 on a quarterly basis through July 2028.
In effect, the TSE is setting up an environment in which companies are incentivized to perform not just as businesses but as stocks. Where it’ll create a subtle environment for “Winner stays on” though not quite like the SP500! The hope of course, is to make the TOPIX and consequently Japan a more attractive investment opportunity.
Note that requirements to stay in the Index is slightly more lax vs the requirements to be included.
But will it matter? The new index will still cover 96.6% of the cumulative free-float market capitalization of the entire stock market (i.e. the cumulative free-float market cap of the new TOPIX constituents vs that of all Prime, Standard, and Growth constituents combined). Prior to the change (compared to Jan 2025 that is), the coverage ratio is 97.7%. This is despite the significant cut in # of stocks to be included - but that’s because there is a long tail of tiny companies that are still in the TOPIX today.
It’s also worth noting that there are so many other TOPIX indices that already exist, like the TOPIX 500 or the TOPIX 1000, but the performance difference has been minimal. Likely because those that don’t meet the threshold are too small to make any meaningful impact and the index is a weighted average.
The TSE also estimates that on fundamentals, there won’t be a significant change after the TOPIX reform. Of note is that both sector exposure and valuation are estimated to be almost the same.
It seems that at the index level things won’t really change whilst at the same time the TSE seems to want the underperformers in the index to do something - which I will pontificate on below.
Potential Outcomes: Opportunity vs Risk
Now from here on are some possible outcomes. This part is more speculative based on my thoughts and information I’ve gathered. Such changes can always invite unintended consequences which we’ll see in time, but for now, I thought about a range of things we could see that are both risks and opportunities.