In the first quarter of 2024, Japan's stock market charged ahead with remarkable vigor. The Nikkei 225 index soared by 8.4% in January and 7.9% in February, and in March, it even briefly broke through the 40,000-point barrier, a feat not achieved since its peak 34 years ago. This milestone signifies the Nikkei's historic high and marks Japan's definitive emergence from the shadow of its "lost 20 years."

The 'wealth effect' is a powerful magnet for investor attention. The stellar performance of the Nikkei 225 has turned global investor focus towards the fertile ground of the Japanese stock market. Grasping the Japanese stock market's dynamics hinges on analyzing its key indices, much like evaluating the U.S. market through the pivotal S&P 500, NASDAQ, and Dow Jones benchmarks.

There are several indices in the Japanese stock market, including the Nikkei 225, TOPIX Index, Nikkei 500, Nikkei 300, TOPIX Core 30, and TOPIX Large 70, among others. The most well-known of these is the Nikkei 225, while the TOPIX Index is recognized for having the broadest coverage of constituent stocks.

This article will focus on providing an in-depth analysis of the Nikkei 225 and the TOPIX Index. It will cover their compilation principles, sector distributions, and constituent stocks, as well as related ETFs.

History and compilation principles of the two major Japanese indices

The Nikkei 225 Index, established by the Nihon Keizai Shimbun in 1970, is Japan's oldest and a price-weighted index tracking 225 leading companies. With a history spanning over seven decades, it began with a base value of 100 points set on May 16, 1949.

The index prioritizes liquidity, selecting the most traded stocks from the Tokyo Stock Exchange Prime Market, and uses price-weighting, where higher-priced stocks carry more weight. This is somewhat similar to the Dow Jones Industrial Average in the US stock market.

The index is calculated as follows:

Nikkei Stock Average = Σ Adjusted stock price of the constituent stocks (225) / Divisor

Adjusted Stock Price = Market price of the stock (in yen) x Price conversion factor

Calculated biannually, the index’s adjustments ensure it remains updated with market changes.

The TOPIX Index, introduced by the Tokyo Stock Exchange in 1969 and market capitalization-weighted, reflects a broader market spectrum with over 2100 stocks, encompassing about 95% of Japan's market value.

It adopts a broad and inclusive approach, now focusing on the Prime Market. Market cap weighting provides a more scientific measure of a company's market influence, with individual stock influence capped at 10%.

Unlike the Nikkei 225, TOPIX uses a market capitalization-weighted approach, covering roughly 95% of Japan's market value. This method ensures that larger companies have a proportionate influence on the index, with a cap of 10% per stock. Market value-weighting is seen as more representative than price-weighting, as it aligns a company's index influence with its overall market strength.

Industry distributions and top constituent stocks of Nikkei 225 and TOPIX

The Nikkei 225 Index is predominantly segmented into six sectors, including consumer services, technology, finance, and materials. As of February 2024, the technology sector, with 61 stocks, has a commanding 51.1% weight, while consumer services hold a 23.1% weight with 37 stocks. Together, these two sectors comprise 74.5% of the index, indicating that investing in the Nikkei 225 is essentially an investment in Japan's tech and consumer sectors.

The TOPIX Index has a more granular industry classification, spanning over 20 sectors like electronics, services, and machinery. By the end of January 2024, the electronics sector, led by Sony, was the largest, with a 17.4% weight, followed by transportation equipment, including Toyota, with 8.7%, and information and communication, exemplified by Nippon Telegraph and Telephone, at 7.5%.

Looking at individual stocks, Fast Retailing, the parent company of Uniqlo and with a stock price exceeding 40,000 yen, tops the Nikkei 225 with an 11% weight, and the top ten stocks together account for about 42.3% of the index. Notably, Toyota, despite being the largest by market capitalization, has a weight of less than 1%.

In the TOPIX Index, Toyota holds the largest weight at approximately 4.55%, followed by Sony and Mitsubishi UFJ Financial Group, with weights of 2.87% and 2.31%, respectively. The top ten constituents in TOPIX make up about 20.8% of the index weight.

Historical Performance of Nikkei 225 and TOPIX Indexes

The Nikkei 225 and TOPIX are barometers of Japan's economic health. During Japan's economic boom in the 1960s, both indexes rose sharply. The 1980s asset bubble saw their peak, with the Nikkei reaching 38,915.87 in 1989 and the TOPIX hitting 2,886.5. The 1990s burst led to a dramatic fall, exacerbated by the 2001 terror attacks and the 2008 financial crisis, bottoming out in 2009.

Japan's "Lost 20 Years" ended with Shinzo Abe's "Abenomics" in 2012, fueling a stock market rebound. Recently, the Nikkei broke through 40,000 points in February 2024, a 34-year record, while the TOPIX neared its all-time high at 2,755 points.

How to Invest in the Nikkei 225 and TOPIX Indexes

The robust performance of the Nikkei 225 and TOPIX Indexes may attract investors. To invest in these indexes, one cannot invest directly in the indexes themselves, as they are merely tools for tracking market performance. However, investors can gain exposure through vehicles such as Exchange-Traded Funds (ETFs) and index futures tied to the Nikkei 225. Of these, broad market index ETFs are a common investment choice.

In the Japanese market, there are primarily seven ETFs tracking the Nikkei 225. As of March 14, 2024, the combined assets under management of these ETFs reached approximately 51.3 trillion yen. The largest among them is the NEXT FUNDS Nikkei 225 ETF, with assets of about 42.9 trillion yen.

There are primarily six ETFs tracking the TOPIX Index, with a total scale of approximately 36.9 trillion yen. The largest among them is the NEXT FUNDS TOPIX ETF, with a scale of about 22.3 trillion yen.

In summary, the Japanese stock market's rally has drawn global investor interest. The Nikkei 225 and TOPIX indexes are key to understanding this market.

The Nikkei 225 consists of 225 liquid stocks and is price-weighted, while the TOPIX covers Prime market stocks and is market-cap weighted.

Both reflect Japan's economic health, which has experienced significant fluctuations in line with Japan's economic cycles. In February 2024, the Nikkei 225 Index broke its historical high, and the TOPIX 500 Index also neared a new high.

Investors can access this market through ETFs, with seven tracking the Nikkei 225 and six tracking the TOPIX.

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