Japan index compilers rush to please BOJ and excite normal investors

A man walks into a tailor, orders a custom-made suit and then says he’s bound by his own rules to only buy half of it. Sell the rest to someone else, he says.

That, essentially, is the conundrum facing S&P Dow Jones Indices, except that instead of a suit, it’s designing a stock gauge to the specifications of the Bank of Japan.

The central bank wants to buy baskets of shares based on indexes that pick companies partly on whether they raise wages. Salaries are a key battleground in the BOJ’s efforts to spur inflation, and firms have so far been hard to budge.

There are two problems. First, the BOJ says it can only own half of each exchange-traded fund tracking such indexes. In other words, for the measure to succeed, other customers have to like it, too. And second, as Jesper Koll of Wisdomtree Investments Inc. said earlier this year, no sensible investor would see higher salaries as the sole reason to buy a company’s shares.

“No one will want to buy it” unless the new gauge outperforms the benchmark Topix index, Yoshiyuki Makino, head of the Japan office of S&P Dow Jones, said in an interview in Tokyo. Still, “you understand our government is very keen to” raise wages, he said.

The BOJ said in December it would spend ¥300 billion a year on ETFs tracking companies that are “proactively making investment in physical and human capital,” in addition to the ¥3 trillion a year in ETFs that it already purchases. ETFs containing firms that are boosting staff numbers, wages and spending on employee development would be eligible, as well as those increasing capital or research spending, the bank said in March.

As such funds have never been made in Japan, index and ETF providers have been rushing to create products that meet the BOJ’s requirements while also attracting other buyers.

How is S&P approaching the problem? For starters, it’s not ignoring wage growth. Instead, it’s using it as one factor among many for ranking companies.

Members of the new index will be weighted by their score on capital expenditure and human capital. On the former, S&P will look at both spending growth and efficiency, according to Makino, meaning firms that spend wastefully have less chance of being included.

For human capital, the index compiler will use information from sustainable-investment specialist RobecoSAM, such as on how a company trains its staff, as well as what it pays them. The inputs for that part of the score are expected to run into the double-digits, he said.

“Wages are only one part,” Makino said. “If you design it to only focus on wage increases, it means that one factor will negatively impact companies’ revenue or net income. So we have to carefully manage that one.”

S&P Dow’s index, designed jointly with Japan Exchange Group Inc. and expected to be unveiled this month, will pick 200 firms from the Topix.

That’s enough to provide diversification and remove the possibility of bias to certain industries, Makino said, while not being too many for financial institutions with strict risk-management requirements. He notes that many Japanese banks prefer investing in the Dow Jones Industrial Average to the Standard & Poor’s 500 Index for this reason. In backtesting, the new index has beaten the Topix, he said.

“I think investors would be interested, especially with the knowledge that the BOJ are going to be the big buyers,” said Andrew Clarke, Hong Kong-based director of trading at Mirabaud Asia Ltd. “It’s almost like a government-backed bond. Maybe people will be concerned companies are pushing wages higher and impacting on profit margins.”

Alex Matturri, chief executive officer of S&P Dow Jones, says using stock gauges for social engineering is becoming much more common. For example, his firm and the Canada Pension Plan Investment Board started the S&P Long-Term Value Creation Global Index in January. The measure chooses companies focused on sustainable growth in response to concern about short-term thinking in markets.

“You’re going to see more of these kinds of concepts, of using indices as a way to dictate government policy,” Matturri said. “You see it in the U.S. with some of the biggest public plans because they feel it’s an obligation to not just maximize returns but to achieve a certain social outcome.”

It’s also not Japan’s first such experiment. The JPX-Nikkei Index 400, started in 2014 as part of Prime Minister Shinzo Abe’s growth strategy, is meant to showcase the nation’s most profitable and capital-efficient firms. It also seeks to shame those that miss the cut into doing more with their hoards of cash. While some executives changed their strategies to make the measure, performance for investors is almost the same as the Topix.

Matturri says academic research is unclear on whether ESG indexes can beat the market. Still, some buyers may not care.

“Here you’re trying to get the maximum return for a given level of outcome,” he said. That “could reduce possible return or it may not. Time will tell. If it’s designed right, hopefully it won’t.”