Prime Minister Sanae Takaichi's economic stimulus programs and market-friendly reforms have driven a notable surge in Japan's stock market in recent years. However, the nation's most closely watched benchmark—the Nikkei 225—may actually be hiding a critical structural problem that investors should consider carefully.
Unlike most widely followed stock indices around the world, which use market capitalization to decide the weight each stock holds in the index, the Nikkei 225 is built on a price-weighted system. This means that the stocks with the highest current prices—no matter how many shares are in circulation—have the most influence over the index's performance.
Ali Masarwah, managing director at the independent fund broker Envestor, calls this design a 'construction disaster.' He argues that the structure explains the index’s recent volatility and its heavy concentration in a small number of companies. These are often from fast-moving, high-growth sectors like artificial intelligence and semiconductors.
One of the top companies in the Nikkei 225, Tokyo Electron, is set to announce a one-for-five stock split on September 30. This will reduce the stock's price per share but will not alter its fundamental value or overall market capitalization. Such events can have a greater impact on the Nikkei than on other types of indices.
Due to its price-weighted nature, this split could create a more pronounced impact on the index. Tokyo Electron’s earlier one-for-three stock split in March 2023 already caused the Nikkei to experience a noticeable drop. Whether the index can bounce back this time is uncertain. Investors who hold ETFs tracking the Nikkei 225 may want to look at alternatives like the MSCI Japan index, which is less sensitive to such changes.
Risks in AI's Shadow
A significant part of the Nikkei 225’s strong performance in recent years has been driven by the sharp increase in valuations of AI-related firms, including Tokyo Electron. However, if the momentum behind the AI industry slows, the index could face a more severe correction than investors might expect.
This dynamic has attracted attention from both retail and institutional investors. ETFs that track the Nikkei have seen strong investment inflows, but the index’s structure may expose these funds to unpredictable swings as the market landscape continues to change.
Longstanding as a symbol of Japan’s financial markets, the Nikkei 225 remains a popular benchmark. Yet, its design may not provide a fully accurate reflection of the broader economic landscape. Investors are being urged to look beyond the headline numbers and consider the implications of the index’s unique construction for their portfolios.