The Japanese stock market has experienced a prolonged cycle of decline and recovery.

After a downturn that lasted two decades, it took an additional 15 years to recuperate.

In February 2024, Japan's financial markets reached a milestone with the Nikkei 225 Index approaching the 40,000-point mark, a level not seen in 34 years.

This resurgence has captured the attention of investors worldwide, who are now keenly exploring opportunities within the Japanese market. Just as the S&P 500 and Nasdaq provide insights into the U.S. market, understanding Japan's market dynamics requires a close look at its key indices.

The Nikkei 225 is Japan's oldest stock index, serving as a market barometer and a focal point for investor analysis.

In this article, we will explore the Nikkei 225 in depth: its industry composition, constituents, historical performance, the rationale behind its recent ascent, and actionable insights for investors considering this market.

What is Nikkei 225?

The Nikkei 225 comprises 225 blue-chip companies listed on the Tokyo Stock Exchange (TSE). It was established in 1950 and is one of the most widely watched indices globally.

The stock selection rules for the Nikkei 225 Index

1. Liquidity: The index prioritizes stocks with high trading volume and market liquidity from the Tokyo Stock Exchange. This selection criterion ensures that the index remains current and reflective of shifts in the market and industry structures.

2. Adjustment frequency: The Nikkei 225 undergoes a review and rebalance semi-annually, typically in April and October. These updates allow the index to adapt to market changes by including strong performers and excluding weaker ones.

3. Price weighting: Stocks are weighted based on their prices. Higher-priced stocks have more influence. This method is similar to how the Dow Jones Average Index works. However, it may not fully represent the impact of large companies. For example, Fast Retailing, the parent company of Uniqlo, has a significant weight despite not being the largest by market value.

In contrast, the TOPIX index in Japan uses market capitalization weighting, where weights are based on a company's market value. It is similar to how the S&P 500 index works.

Source: Nikkei Stock Average Index Guidebook

What are constituent stocks?

If you want to know which industries and stocks are currently the hottest in the Japanese stock market, the simplest way is to look within the Nikkei 225 Index. This is because the constituent stocks of the Nikkei 225 Index are the most actively traded stocks.

1. Industry distribution:

The constituent stocks of the Nikkei 225 Index include 225 representative stocks listed on the Tokyo Stock Exchange. These companies cover various crucial sectors of the Japanese economy, including technology, consumer goods, manufacturing, etc.

However, as the time goes by, there has been a significant transformation in the index's industry structure. As of January 31, 2024, the weight of the Nikkei 225 Index is primarily concentrated in the technology and consumer goods sectors, with weights reaching 49.1% and 23.76% respectively, totaling a high cumulative weight of 72.9%.

In other words, investing in the Nikkei 225 means having significant exposure to the technology and consumer goods sectors, given their substantial weights in the index.

2. Top 10 weighted stocks

The composition of the Nikkei 225 Index is highly concentrated, with the top ten holdings making up around 40% of its total weight. Dominating the index is Fast Retailing, the parent company of Uniqlo, with a substantial weight of 10.94%. Following closely is Tokyo Electron at 7.67%, Advantest at 4.28%, and SoftBank Group at 3.56%.

Other prominent companies in the index include global icons such as Sony, Nintendo, Toyota Motor, and Honda Motor. These firms are not only significant players in Japan but also hold considerable influence in the international market.

Historical trends of the Nikkei 225 Index

The history of the Nikkei Index can be traced back to 1949, spanning over 70 years and witnessing several major economic shifts in Japan.

In the 1960s, Japan entered a period of high economic growth, propelling the Nikkei 225 to new heights. The trend continued into the 1980s when the country experienced an economic bubble fueled by low-interest rates, which further inflated stock prices. This bubble peaked on December 29, 1989, when the Nikkei 225 reached an unprecedented high of 38,915.87 points.

The 1990s, however, painted a starkly different picture. The bursting of the bubble caused a severe recession, as plummeting land and stock prices, along with a deteriorating economy, led to widespread bankruptcies among banks and securities firms. The Nikkei 225 halved in value and stagnated for years, marking what is commonly referred to as the "Lost Decade."

The challenges continued into the new millennium, with Japan enduring economic shocks from the 2011 earthquake, the subsequent Fukushima nuclear disaster, and a devastating tsunami. It wasn't until Prime Minister Shinzo Abe's return to office in 2012 and the implementation of his "Abenomics" policies that the nation saw a turnaround, sparking a prolonged recovery in the stock market. From its nadir in 2009, the Nikkei 225 grew nearly 4.5 times over the next fifteen years.

Most recently, Japanese stocks have experienced a rapid climb. In February 2024, the Nikkei Index soared past 39,000 points, achieving a 34-year record. As of February 27, 2024, the index has enjoyed a significant year-to-date increase of 17.6%.

How to invest in the Nikkei 225 Index

Investors have multiple avenues to invest in the performance of the Nikkei 225 Index, despite not being able to invest directly in the index itself. Among the options available, ETFs are a popular choice due to their ease of use and liquidity.

1. Japanese stock market:

Within Japan, investors can choose from several ETFs that track the Nikkei 225 Index, offering a straightforward way to invest in the index's performance. These ETFs are listed on the Japanese stock market and are yen-denominated, closely replicating the Nikkei 225's fluctuations.

For overseas investors wanting to access the Nikkei 225, there are ETFs available on international markets, such as those in the United States.

Data Source: Japan Exchange Group. The selection criteria for relevant ETFs are all ETFs tracking the Nikkei 225 Index as reported on the Japan Exchange Group.

2. US stock market:

In the US, major Japanese stock ETFs typically do not track the Nikkei 225 directly. Rather, they often follow other indices like the MSCI Japan Index or may employ currency-hedged strategies to mitigate the impact of exchange rate fluctuations.

It's worth noting that exchange rates are one of the important factors that overseas investors must consider. When holding foreign assets, currency fluctuations can lead to gains or losses when converting the assets back into the investor's home currency upon liquidation.

In other words, if your home currency is the US dollar, a depreciation of the Japanese yen against the dollar may offset gains from the index's rise or even result in losses.

To address the issue of currency risk, there are currency-hedged ETFs that aim to align more closely with the performance of their respective Japanese stock indices by hedging against currency risk.

For example, the largest Japanese stock ETF by total assets in the US, EWJ, which tracks the MSCI Japan Index, reported a year-to-date rise of 7.6%. However, its performance may differ from another ETF like DBJP, also following the MSCI Japan Index, primarily due to currency effects. EWJ's returns might be lower because it does not hedge against the yen's depreciation, which can offset the gains from the index's performance.

Data Source: ETF Database. The selection criteria for relevant ETFs are the top five Japanese stock ETFs in terms of total assets in the US stock market, as of February 24, 2024. The year-to-date performance is calculated from the first trading day of 2024 to February 24, 2024.

Risks associated with Nikkei 225 investing:

1. Market volatility:

   The Nikkei 225 can experience significant fluctuations due to economic, political, and external factors, leading to potential losses for investors.

2. Currency risk:

   For non-Japanese investors, changes in the yen's value against their home currency can affect returns.

3. Geopolitical uncertainty:

   Regional or global political tensions can impact market stability and investor confidence.

4. Sectoral risks:

   Specific industries within the index may face unique challenges, influencing stock performance.

Summary

1. The Nikkei 225 Index tracks 225 highly liquid stocks on the Tokyo Stock Exchange, representing the broader stock market in Japan.

2. Selection is based on liquidity; it's price-weighted and reviewed semi-annually.

3. Major stocks in the index like Fast Retailing and Tokyo Electron come from sectors like technology and consumer goods.

4. The index reflects Japan's economic changes, recently achieving a significant milestone.

5. Investors can access the index indirectly through ETFs, actively managed funds, or index futures. Broad market ETFs are common choices in Japanese and Hong Kong/US markets.

6. Risks to consider include market, currency, geopolitical, and sector-specific risks.