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BOJ quantitative easing is distorting the Japan stock market. Here’s how to play it

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The Bank of Japan's purchases of the country's exchange-traded funds (ETFs) has been distorting the market, offering traders a leg up on picking stock winners.

Japan's central bank has been scooping up ETFs and the numbers are large enough to sway markets. At its late July meeting, it said it would increase its ETF purchases so that their amount outstanding will rise at an annual pace of 6 trillion yen ($56.7 billion), from 3.3 trillion yen previously.

The book value of the BOJ's ETF holdings was 8.7 trillion yen at the end of July, Citigroup said, citing BOJ data, with the investment bank estimating the market value of 9.7 trillion yen at that time.

That's introducing distortions into Japan's stock market, not just from the amount, but also due to the makeup, with more than 50 percent of the purchases in ETFs tied to the Nikkei 225 index, analysts said.

That's because the Nikkei 225 index is weighted by the price of individual stocks, compared with other indexes, such as the broader Topix, which are weighted by market capitalization. Indeed, in a note dated Sunday, CLSA analyst Nicholas Smith called the Nikkei 225 a "Flintstones index from an abacus age."

But the BOJ's focus on Nikkei 225-tied ETFs can open up opportunities for traders.

For one, analysts have advised focusing on sectors strongly represented in the Nikkei index, rather than the Topix.

"If the BOJ were to continue to purchase mainly ETFs linked to the Nikkei average, we would recommend overweighting sectors with high weightings in the Nikkei, namely retail, electricals, information and communications, pharmaceuticals, and chemicals," Citigroup said in a note dated Tuesday.

"At the individual stock level, we would overweight names with high ratios of BOJ purchases to trading value and stocks that are overweight in the Nikkei average and underweight those which are underweight in the Nikkei average," it added.

Stocks with a high ratio of BOJ purchases to trading value included Takara Holdings, Kyocera, Fast Retailing and NTT Data, Citigroup noted.

But Citigroup also recommended staying underweight stocks where the BOJ was a major shareholder as that could spur corporate governance concerns as a perpetually supported share price could weigh on management discipline.

CLSA's Smith made similar recommendations, saying Toyota was being removed from the brokerage's model portfolio and replaced with Fast Retailing, which is the highest-weighted stock in the Nikkei index. CLSA also added Softbank to its model portfolio as the fourth-most overweighted stock in the Nikkei, replacing Hulic, which wasn't in that index.

"It is disappointing to be forced to invest in such a non-fundamental way," Smith said.

But there were reasons for caution before pursuing the trading strategy.

For one, the BOJ planned to use its September meeting to conduct a comprehensive assessment of the effectiveness of its policies.

Citigroup said that would likely offer the central bank a good opportunity to change its methodology.

"We think the BOJ needs to rethink its approach to purchases of ETFs so that it is mainly buying Topix-linked ETFs," the bank said, noting if the change were made it would flip its strategy to pursue stocks overweighted in the Topix compared with the Nikkei.

"Were the BOJ to rethink the way it purchases ETFs, then the benefits could accrue more to electric power and gas, land transportation, wholesale, transport equipment, and banks, which have low weightings in the Nikkei average," it said.

Citigroup noted that the six Topix-linked ETFs had total market capitalization of 5.8 trillion yen at the end of July, compared with the eight Nikkei 225 ETFs at 7.7 trillion yen. Citigroup estimated that the BOJ was buying ETFs at levels proportionate to their market capitalizations, working out to 54 percent for the Nikkei 225 ETFs, 41 percent for Topix-tied ETFs and 5 percent for others, which included the six JPX-Nikkei 400 index ETFs, which had a market capitalization of around 630 billion yen at the end of July.

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—By CNBC.Com's Leslie Shaffer; Follow her on Twitter