Aug. 27 (Bloomberg) -- Two years after being plucked from the ranks of exchange product developers to design the JPX-Nikkei Index 400, Daisuke Tanaka finds himself at the center of a corporate revolution.
Bespectacled and lean at 40, the lifelong employee of Japan Exchange Group Inc. is executing a plan backed by the government to shame corporate executives into boosting profits rather than hoarding cash. Tanaka’s index, which aims to stoke the economy, is changing company behavior and winning fans such as Goldman Sachs Group Inc. even as detractors deride its makeup and say it will cause investors to buy when valuations peak.
“I feel glad we’ve made this measure,” Tanaka, who only started studying equity gauges four years ago, said in an interview in Tokyo on Aug. 13. “I’ve no regrets about how we set it up.”
Tanaka is at the forefront of an experiment in corporate engineering with an index, considered by some to be a smart beta gauge, that ranks companies on profit measures such as return on equity as well as market value. The gauge started in January and drew attention when Sony Corp. was kicked out this month.
Specialized indexes are gaining global traction with investors seeking to cut down on asset-management costs. Smart beta funds accounted for about 18 percent of U.S. exchange-traded assets at the end of 2013, including exchange-traded notes, and grabbed 31 percent of exchange-traded fund net deposits in the year, according to Morningstar Inc.
Indexes matter because institutional investors use them as a guide when buying stocks. Planners from Prime Minister Shinzo Abe’s Liberal Democratic Party had been discussing the idea of a gauge to showcase Japan’s most shareholder-friendly companies and brought their plan to the exchange. JPX says the measure was its own creation.
Almost $2 billion was tracking the gauge as of Aug. 7 in four ETFs and 19 investment trusts, JPX President Atsushi Saito said this month. The $1.2 trillion Government Pension Investment Fund had about $1.5 billion following the measure through three passive funds, it said July 4. The Bank of Japan is considering buying ETFs linked to the measure, people familiar with the matter said in July.
The JPX-Nikkei 400 slid 0.7 percent this year through yesterday, compared with a 1.3 percent decline for the Topix index and a 4.7 percent drop for the price-weighted Nikkei 225 Stock Average. The so-called shame gauge was little changed today, while the Topix and Nikkei 225 both rose 0.1 percent.
“When we built it, we didn’t know whether the funds would come,” Tanaka said in the interview. “There was a possibility nobody would.”
Tanaka got the call to design the JPX-Nikkei 400 after dabbling with lesser-known measures, including a leveraged index whose value rose as the Topix fell.
The idea was to pick the most capital-efficient companies, Tanaka said. While ROE was important, selecting businesses solely for the profit they generate from shareholders’ funds wasn’t an option, he said.
“If we chose based just on ROE, many things wouldn’t work on a practical level,” Tanaka said. “ROE is a percentage, and the numbers jump around a lot each year. It’s not stable. Many companies would be replaced each year, which would increase costs for investors, making the index useless.”
The planners added operating income, because it would favor companies making profit from their chosen business, and market value to reflect stock appreciation, Tanaka said. Three-year average ROE and cumulative operating profit each received a 40 percent weighting, with the rest representing market capitalization.
Tanaka said he gives himself 80 points out of 100 for his creation, although not because there’s anything wrong with it. He doesn’t want to be seen as arrogant for giving himself a perfect score.
Others would assign a lower grade. The index is flawed, according to Nicholas Smith, a strategist at stockbroker CLSA Ltd. in Tokyo, because size outweighs return on equity. Companies with low shareholder returns can sneak in if they rank high on other criteria, he said, citing Sony and Nomura Holdings Inc.
Sony’s three-year average ROE was negative 9.1 percent when the gauge was first compiled. The stock was dumped in the first reshuffle as dwindling operating profit and market value pushed it out of the top 400. Nomura, Japan’s largest brokerage, remains in even with a three-year average return on equity of 4.8 percent, compared with a current ROE of 8.9 percent for the index.
The JPX measure has another weak spot: it will pick stocks with high ROE at the top of their cycle, when investors should be selling them, according to Smith. The underlying premise that indexes can benefit investors by tweaking their criteria is wrong, he said.
“Smart-beta indexing doesn’t work,” he said. “It outperforms in some markets and underperforms in others.”
Buying companies not on the index may be the best investment strategy, according to JPMorgan Chase & Co. As ROE is easier to boost than market cap and operating profit, cash-rich companies with positive earnings forecasts such as lender Tomony Holdings Inc., may conduct buybacks to try to climb on, JPMorgan analysts wrote in a report on Aug. 11.
The hardest thing about designing the gauge was moving it from an idea into a working index, according to Tanaka, who said he’d sometimes take the last train home after working late on the project.
His team ran more than 1,500 simulations to arrive at the criteria, he said. The focus was on finding a mix that would work, because the index never intended to showcase only return on equity.
“There was no point creating an index that wouldn’t be used,” Tanaka said. “We wanted something practical that asset managers could rely on.”
There are signs companies are taking the measure seriously. Kawasaki Kisen Kaisha Ltd., Japan’s third-largest shipper, jumped 3.3 percent today. The company adopted an ROE target for the first time because investors are placing more weight on it, and is seeking returns of 10 percent in five years, the Nikkei newspaper reported, citing President Jiro Asakura.
Amada Co., one of 74 firms from the Nikkei 225 left off the JPX-Nikkei 400 when the gauge started, pledged in May to pay out about half its profit in dividends and spend the rest on stock buybacks to get cash off the balance sheet and boost return on equity. Minebea Co., a bearings maker that got on in the measure’s first reshuffle, said this month it’s targeting record ROE of 20 percent in the next three fiscal years.
“This index is about making things better for all Japanese companies,” Tanaka said. “We want those that don’t make it to try to get on. We’ve no intention of writing the rejects off.”
To contact the editors responsible for this story: Sarah McDonald at email@example.com Tom Redmond, John McCluskey