After a three-month hiatus, the Japanese stock market has finally regained its momentum. The Nikkei 225 index surpassed the 40,000-point mark again on Tuesday, and the TOPIX index reached its 34-year high last week.

On Wednesday, Japanese stocks continued to rebound. The Nikkei 225 index rose 1.3% to close, and the TOPIX index rose 0.5%. Over the past five trading days, the two major stock indexes have accumulated gains of 3.3% and 2.8%, respectively.

Behind the rally in Japanese stocks is a record number of foreign and retail investors holding shares. On the one hand, due to the optimistic prospects for the end of deflation, loose monetary policy, and improved corporate governance, overseas funds have poured into Japan. On the other hand, the sharp rise in Japanese stocks earlier has significantly boosted public confidence, and stock splits by listed companies have reduced the threshold for retail investors to enter the market.

A large amount of funds flowed into Japanese-related ETFs last week, and ETFs that did not hedge against exchange rate risks underperformed the market due to the sharp depreciation of the yen.

Foreign and retail investors both set records for holding Japanese stocks.

A survey released by the Tokyo Stock Exchange on Tuesday showed that the number of individual shareholders of companies listed on the four major securities exchanges in Japan in fiscal year 2023 increased by 4.62 million from the previous year to a record high of 74.45 million.

The increase in the number of retail investors is not only due to the stimulation of rising stock prices. Companies such as NTT have implemented stock splits, which have reduced the price per share and made it easier for individuals to buy stocks.

The survey also showed that about 2.47 million individuals became new shareholders of companies that implemented stock splits, including 1.06 million new shareholders added by NTT (which underwent a 25:1 stock split), and about 110,000 new individual shareholders added by Tokyo Disney Resort operator Oriental Land and trading company Mitsubishi Corp.

In addition, the new version of the Japanese personal savings account (NISA) tax-free program, which began in January this year, has also promoted an increase in the number of individual investors. The plan is aimed at small investors.

While the number of domestic retail investors has soared, the proportion of Japanese stocks held by foreign investors rose to a new high last year.

Data released by the Japan Exchange Group on Tuesday showed that the total value of stocks held by foreign investors accounted for 31.8% of the total at the end of the fiscal year (March 31, 2023), the highest level since comparable data became available in 1970. The proportion was only 4.9% in 1970. The proportion of individual investors was 16.9%, while that of financial institutions was 28.9%.

In addition, foreign purchases increased to 320 trillion yen ($2 trillion) last fiscal year, up more than 40% from a year ago. They became net buyers for the first time in three years, with a net purchase of 7.7 trillion yen.

Why is there such a big difference in returns among Japanese stock ETFs?

Corresponding to the rise of the market, exchange-traded funds (ETFs) trading in Japan have also seen a large inflow of funds, rising by more than 2% as a whole last week.

Among them, iShares MSCI Japan Euro Hedged UCITS ETF (IJPE) rose 3.44% last week, while Amundi MSCI Japan ESG Climate Net Zero Target CTB UCITS ETF (CJ1P) rose 2.42%. Both ETFs benefited from the rising market, reduced volatility, and positive outlook brought by stabilizing inflation.

However, it is worth noting that although Japanese-related ETFs have risen significantly, there is a huge difference in performance among them.

Take the EWJ and HEWJ under the iShares of BlackRock as an example. In the past year, while the Japanese stock market rose by about 20%, EWJ had a return of about 10%, while HEWJ had a return of about 30% due to its hedging against exchange rate risks.
Exchange rate hedging is the main reason for the performance differentiation of ETFs. EWJ tracks the MSCI Japan Index, and its holdings are mainly Japanese company stocks. HEWJ is a hedged version of EWJ. Over 90% of its holdings are EWJ's holdings, while it also holds US dollar cash, yen-denominated US dollar forward contracts, and US dollar money market funds.

Due to the high US interest rates and the slow pace of yen rate hikes, there is a huge interest rate differential between the two currencies. In the past year, the yen has fallen by more than 12% against the US dollar, and last week it fell below the 160 mark, hitting a new low since December 1986. As of the time of writing, the USD/JPY exchange rate is trading at a lower level of 161.79.

Therefore, if the ETF does not hedge against exchange rate risks, the sharp depreciation of the yen will significantly offset the gains brought by the rise of Japanese stocks.