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Here’s how to play the Bank of Japan’s changes to its asset-purchase program for ETFs

Peter Dazeley | Photographer's Choice | Getty Images

The Bank of Japan has radically shifted how it will purchase exchange-traded funds (ETFs) in Japan's stock market. Here's how to play it.

As part of its quantitative and qualitative easing (QQE) program, the BOJ has been purchasing ETFs at an annual rate of around 5.7 trillion yen ($56.12 billion), spread among three indexes: the Topix, the Nikkei 225 and the JPX Nikkei 400 in amounts roughly proportionate to the ETFs' market value.

That spurred complaints the market was being distorted as the purchases were skewed toward the Nikkei index, which is weighted by the price of individual stocks, compared with other indexes, such as the broader Topix, which are weighted by market capitalization.

In a likely move to address those concerns, the BOJ said after its policy-setting meeting on Wednesday that now 3 trillion yen of its purchases would still be divided among ETFs based on the three indexes, roughly proportionate to the ETF's total market value.

But the central bank added that the remaining 2.7 trillion yen would be aimed only at funds tracking the Topix index. It said the 300 billion yen allocated to ETFs tied to "supporting firms proactively investing in physical and human capital" would be unchanged.

In a note on Wednesday, analysts at Nomura estimated the change meant around 70 percent of funds would be allocated to the Topix index, 28 percent to the Nikkei and 2 percent to the JPX Nikkei 400, compared with an estimated 42 percent, 53 percent and 4 percent respectively, previously.

That was a likely driver of the Topix index's outperformance on Wednesday, when it closed up around 2.7 percent, compared with the Nikkei's 1.9 percent gain. Japan's markets were closed Thursday for the autumnal equinox holiday.

Nomura expected the biggest gainers from the change would likely be among the low-liquidity small-capitalization stocks included in the Topix.

Nomura's list of the top-60 stocks set for a positive impact from the change weren't likely to be household names. For example, Nomura expected Chuo Warehouse, a warehousing and harbour transportation service provider, would benefit the most, followed by steel player Mory Industries and Taki Chemical.

Among the 60 stocks likely to be most negatively affected, Nomura pointed to shares highly weighted in the Nikkei index, including NTT Data, Fast Retailing and Kyocera.

One of the complaints about the Nikkei index has been that it uses the stock price to set the weights within the index.

For example, Uniqlo owner Fast Retailing had the largest weighting in the Nikkei index, but that was primarily due to its high share price after avoiding any stock splits since April 2002. Toyota Motor, which has the highest market capitalization of any stock in Japan, was only 15th by weight in the index.

Citigroup also advised shifts in allocations to Japan stocks based on the BOJ's purchase shift, adding that it expected the central bank would need to gradually pivot even further toward the Topix and away from the Nikkei.

There would likely be a performance reversal for sectors overweighted and underweighted in the Nikkei index, Citigroup said in a note Wednesday. It had previously estimated that more than 50 percent of the BOJ's ETF purchases had been weighed toward the Nikkei index.

"We could see renewed acceleration in sector rotation away from expensive defensives and domestic-demand stocks and toward cyclicals, exporters, and financials," it said.

In a previous note, Citigroup had highlighted that sectors with higher weightings in the Nikkei than in the Topix included retail, electronic equipment, information and communications, pharmaceuticals and chemicals, while those with lower weightings included banking, transportation equipment, land transportation and electric power.

In addition to the sector swing, there's another reason to expect bank shares to continue to rally.

On Wednesday, the BOJ said it would also change how it purchases Japanese government bonds (JGBs) to target a steeper yield curve.

Critics had noted that the BOJ's historical bond-buying efforts had flattened the government bond yield curve. That tends to weigh on the earnings of banks because they borrow at short-term rates to lend at long-term rates; the lack of compensation for taking on risk also tends to discourage banks from lending.

So in addition to further Topix-related flows likely headed for bank shares, the banks themselves may see better earnings ahead.

That was a likely driver of the surge in Japanese banks' shares on Wednesday, with SMFG jumping 7.3 percent, Resona Holdings climbing 8.09 percent, Mizuho Financial tacking on 6.8 percent and Nomura advancing 5.0 percent.

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—By CNBC.Com's Leslie Shaffer; Follow her on Twitter @LeslieShaffer1