NLI Research — Topix Reform: Phase 2 and its impact

The NLI Research Institute published a report analyzing the second phase of the TOPIX reform initiated by the Japan Exchange Group (JPX). The reform aims to enhance the index’s functionality as an investment target while maintaining its representative nature of the Japanese stock market. The report summarizes the reform schedule, assesses the impact on the index composition and individual stock prices, and discusses the potential consequences of these changes.

Background

The TOPIX, initially designed to reflect stock price trends and the overall Japanese economy, has evolved into a significant benchmark for passive investment strategies. Growing demand for an index with enhanced market representativeness and investability has fueled the need for a comprehensive reform.

Phase One of the TOPIX Reform

The first phase of the reform, implemented in April 2022, decoupled the index from market segments and introduced a phased weight reduction for stocks with a free-float market capitalization below 100 billion yen. This process will culminate in the complete exclusion of these stocks from the TOPIX by January 2025, reducing the number of constituent stocks from approximately 2,200 to 1,700.

Phase Two: Focus on Liquidity and Market Representation

The second phase of the reform, outlined in the report, focuses on enhancing liquidity and market representation. Key changes include:

• Expanded Scope: The index will encompass stocks listed on the Prime, Standard, and Growth markets of the Tokyo Stock Exchange.
• Annual Review: An annual review will be conducted to ensure the index reflects the current market dynamics.
• Liquidity-Based Selection Criteria: Stocks will be selected based on two liquidity criteria: annual trading value turnover and cumulative free-float market capitalization ratio.
• Phased Transition: A phased transition mechanism will be implemented for both newly included and excluded stocks to minimize market impact.

Impact of Phase Two

JPX estimates that the second phase will further reduce the number of constituent stocks to approximately 1,200. While this reduction is significant, the overall characteristics of the index, including free-float market capitalization, market coverage, sector representation, size, and fundamentals, are expected to remain largely unchanged. However, the exclusion of less liquid small-cap stocks is projected to increase the average free-float market capitalization and daily trading value of the constituent stocks.

Analysis of Stock Price Reactions

To assess the market’s reaction to the proposed changes, the report analyzes the stock price performance of potential inclusion and exclusion candidates following the announcement of the second phase reform on June 19, 2024.

• Inclusion Candidates: Stocks identified as potential inclusion candidates exhibited positive price performance, outperforming both the TOPIX and TOPIX Small indices. This suggests that the market views inclusion in the TOPIX as a positive signal.
• Exclusion Candidates: Stocks identified as potential exclusion candidates underperformed the TOPIX and TOPIX Small indices. However, the magnitude of the underperformance was relatively small, indicating a muted market reaction.

The report attributes the contrasting reactions to the different transition mechanisms for inclusion and exclusion. While excluded stocks will undergo a gradual eight-step weight reduction, newly included stocks will have their weights increased in two steps, with 75% of their free-float market capitalization included in the first step. This more immediate inclusion may contribute to the positive price reaction observed for inclusion candidates.

Comparison with Phase One

The report also compares the market reaction to the second phase announcement with the reaction to the first phase announcement in 2020. Similar to the second phase, the first phase announcement did not trigger significant stock price movements for either inclusion or exclusion candidates.

Implications and Future Outlook

The TOPIX reform is a significant development in the Japanese stock market. While the changes are aimed at improving the index’s investability, ongoing debate exists regarding the optimal number of constituent stocks and the appropriate criteria for inclusion.

The reform highlights the importance of liquidity and market capitalization for companies seeking inclusion in the TOPIX. It also presents opportunities for small and mid-cap companies to enhance their corporate value and increase their visibility in the market.

The report concludes that the TOPIX reform, while potentially affecting individual stocks, is likely to have a limited impact on the overall index. It emphasizes the importance of continuous monitoring and evaluation of the reform’s impact on market dynamics and investor behavior.

Please follow us to read more about Finance & FinTech in Japan, like hundreds of readers do every day. We invite you to also register for our short weekly digest, the “Japan FinTech Observer”, on Medium or on LinkedIn. Our global Finance & FinTech Podcast, “eXponential Finance” is also available through its own LinkedIn newsletter, or via our Podcast Page.

Should you live in Tokyo, or just pass through, please also join our meetup. In any case, our YouTube channel and LinkedIn page are there for you as well.