A Japanese national flag is hoisted at Bank of Japan headquarters in Tokyo...A Japanese national flag is hoisted at Bank of Japan headquarters in Tokyo February 25, 2013. Japan's prime minister is likely to nominate an advocate of aggressive monetary easing - Asian Development Bank President Haruhiko Kuroda - as the next central bank governor to step up his fight to finally rid the country of deflation. REUTERS/Yuya Shino (JAPAN - Tags: BUSINESS POLITICS) pworld
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From July 29, when the Bank of Japan said it would nearly double its annual purchases of exchange traded funds from ¥3.3tn ($32bn) to ¥6tn, brokers in Tokyo have been selling stocks with a simple, unsettling message.

In an equity market where the central bank is the biggest whale, and where the government in various forms has become the biggest shareholder in a quarter of First Section Tokyo stocks, it’s time to buy the fund flows, not the fundamentals.

By way of apogee of the new abnormal, CLSA’s strategist Nicholas Smith removed Toyota from his model portfolio and replaced it with Fast Retailing — a stock disproportionately favoured by its trading history and the opaque way in which the Nikkei 225 Average is constructed. More broadly, he said, the BoJ will skew performance towards a particular basket of small and medium names.

The fund flow trade, in different variations according to the brokerage, plays on the warping effects that the central bank’s ETF buying programme are having on equity, bond, currency and Reit markets.

For day traders, there is the short-term phenomenon of guessing when the BoJ will come into the market, and buying moments before that happens. But for the longer term players, still absorbing the distortions created by the negative interest rate policy announced in January, investors are finding themselves overwhelmed with unintended consequences of central bank moves.

The BoJ’s ETF programme, which strikes many investors as a signal of the deepening desperation of governor Haruhiko Kuroda and the broader breakdown of Abenomics momentum, is designed to boost stocks, stimulate growth and encourage individuals to invest in their own market.

The BoJ’s ¥6tn buying programme, which was limited to just ¥450bn per year when it began in 2010, makes the central bank larger than any other investor bloc on the Japanese market. Only once in the last decade has any group purchased more than ¥6tn in a year: foreigners in 2013 when they piled into the Abenomics story and what they believed was the prospect of widespread structural reform. But now it no longer makes sense, said the head of one Tokyo trading desk, to peddle any greater narrative than the fact that the BoJ, according to its current schedule, must buy an average of ¥70bn worth of ETFs every three trading days throughout the year.

Distortions already created by this massive programme, says JPMorgan’s FX strategist Tohru Sasaki, include a breakdown of certain long-held assumptions. Where in the past, a rising yen might batter Japanese shares, the fact that the BoJ will now buy regardless is suspending that pattern.

“With this helicopter money-like policy prevailing over the Japanese stock market,” said Mr Sasaki, “correlation between the Nikkei index and the dollar-yen rate has started to weaken. Even if stock prices decline in the morning, the decline tends to be limited because it is basically known that the BoJ will purchase ¥70.7bn** of ETFs in the afternoon.”

Similarly Nomura’s Real Estate Investment Trust (Reit) analyst Tomohiro Araki said that, while the TSE Reit index had outperformed the Topix index by 21 per cent since the start of 2016, the BoJ now created the “possibility of equities outperforming Reits for reasons separate to underlying merits”.

But it remains in the equity markets that the biggest issues are likely to arise. According to its disclosed methodology, the central bank will buy ETFs in proportion to the market weights of the indices they track. Based on current capitalisations, analysts estimate that more than half of the funds would flow to the Nikkei 225 and two-fifths into the Topix. The balance is destined for the smaller JPX400, made up of companies chosen based on corporate governance criteria.

CLSA points out that this overemphasises the Nikkei 225, with a distorting flow towards certain Nikkei constituents. Unlike the Topix, for which members are weighted according to size and free float, Nikkei weights are calculated proportional to share prices.

As a consequence, companies with high share prices and thus high Nikkei 225 weightings are receiving more inflow than might be justified by their size. Fast Retailing, for instance, is weighted at more than 8 per cent of the Nikkei based on its having the second highest share price in Japan.

Based on its market capitalisation ¥3,870bn ($37.9bn) and free float (25 per cent), its weighting in the Topix is just 30 basis points. Toyota Motor, by contrast, has a lower weighting in the Nikkei than in the Topix, and will be the subject of less buying than justified by its size.

Goldman Sachs estimates that the doubling in BoJ buying coupled with the skew towards Nikkei weightings means that the central bank will own at least one-tenth of the equity in 32 companies by this time next year, up from five currently.

Over the coming 12 months, the government will buy an additional 5 per cent or more of the outstanding equity in small- and medium-sized companies including Taiyo Yuden, Comsys HD, Nissan Chemical and Konami.

But arguably one of the defining distortions of the BoJ’s programme is political.

Pushing against the BoJ’s policy to buy up listed companies stands the Tokyo Stock Exchange’s mandate on corporate governance — a key strut of the Abenomics programme and one of its more visible successes.

As part of a push to lift returns, the TSE introduced a corporate governance code last year — compliance with the code lies behind the selection criteria for one of the BoJ’s target indices, the JPX400.

One aspect of compliance relates to the Japanese tradition of corporate cross-holdings. The TSE wants companies to reduce their interests in other operating companies.

Companies have been slow to release all that pent-up stock on to the market: now that they are finally feeling the pressure to do so, they may find that they are simply selling it into the BoJ’s mega-purchasing programme.

**This figure has been amended to show the correct currency.

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