The fear of NKY

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If the data do not prove that indexing wins, well, the data are wrong. : Jack Bogle

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NKY is the ticker for Nikkei 225, one of the leading stock market index for Japan, which made a new all time high this week. What was most extraordinary is that the all time high came after 35 years!? That's not a typo - NKY last made an all time high in the Tokyo Boom of 1989.

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This makes NKY a darling for active investors - a cautionary tale?from the second largest stock market that indexing can fail for long periods of time.

And that active management would win the day where indexing failed for so long.? This is contrary to everything we have seen in pretty much any other major stock market. So, what gives? Are?NKY and Japan?then the anomaly?

Not so fast. ?

One, the?NKY index?is?a price weighted index. The weight of the constituent?is based on the price of the company stock and not the market capitalisation of the company as it is in market cap weighted indices. Nifty 50 is a free-float market capitalisation weighted?index, meaning market cap ex-promoter holding is used to decide holdings of the company within the index.

This can lead?to bizarre outcomes. For example here are the top 5 companies?in Japan with their stock prices. ?

In a price weighted index MUFG the second largest company will have approximately 1/46th the weight of Keyence, the fourth largest company. Needless to say, a price weighted index will then behave?very differently and it cannot be expected to have same characteristics as a market cap weighted index.

Second, if we look at the market cap of all Japanese companies it was ~$3.8Tn in 1989 and it is ~$6.2Tn now. Yes, Japanese companies were widely overvalued in 1989 and Japan probably suffered a lost decade or two in terms of returns, but a lost decade has happened to Nasdaq and Nifty 50 too.

Finally, S&P runs an?index versus active analysis on Japanese funds?where they compare active investor performance to?good old market cap weighted indices. What do they find? ?

The data is clear. Active funds find it super hard to beat relevant?indices?in Japan. Even for mid/small cap fund managers barely half were able to outperform the relevant market cap weighted index.

The claims that?active portfolio management can somehow do better than index?in Japan are?unsubstantiated in data - investors are still better off investing in the Index, even when index performance is not good!?Except?in Japan, as in anywhere else globally, be careful and invest only in a market cap weighted index and not a price weighted index.?

Happy investing.

Gaurav Rastogi ,? CEO | kuvera.in