In 1995, Nomura Research Institute and Frank Russell Company’s index group partnered to create the Russell/Nomura Japan Equity Indexes (RNJEI) as benchmarks for the Japanese equity market. The year 2015 marks the 20th anniversary of the creation of the RNJEI series and provides a good opportunity to evaluate the effectiveness of the indexes.

The RNJEI series was created to accomplish several objectives:1

• Comprehensive – The primary objective was to provide a broad-market index that accurately measures the performance of the total equity market of Japan. The Russell/Nomura Total Market Index was the first index to consider all Japan-domiciled stocks for inclusion, including stocks from exchanges other than the Tokyo Stock Exchange First Section.

• Float-adjusted – Constituents were weighted according to their availability for investment in the market. Adjustments for cross-holdings and shares unavailable for trading resulted in accurate float-adjusted market capitalization weights. Although adjustment for float is standard index construction practice today, this feature was innovative at the time. The resulting Russell/Nomura Total Market Index was designed to be more representative of the Japanese equity market than other existing indexes.

• Modular – Another objective was to provide an internally consistent series of indexes that added up to the Russell/Nomura Total Market Index. At launch, the RNJEI series included modular components that spanned the size dimension from large to small cap stocks. In addition, value and growth style indexes were created for the Japanese equity market for the first time.2 The resulting index series provided a comprehensive and flexible set of tools for investors.

• Transparent – A final objective was to provide unambiguous and transparent rules for construction of the indexes. Clear rules for construction, stated in advance, are hallmarks of desirable indexes. For indexes to be used as benchmarks, such properties are essential.3 The RNJEI series was constructed with the same rigor Frank Russell Company used in constructing its series of U.S. indexes, launched in 1984.

The resulting benefits of these accomplished objectives include:

A comprehensive series of indexes that spans the size dimension and the value/growth style dimension, for use as benchmarks and as the basis for passive investments by asset owners and managers. See Appendix 1 for a depiction of the relationships among the RNJEI series members.

A representation of the entire investment opportunity set, rather than partial or narrow segments of the market. Generally, academic research suggests that the broadest benchmark that encompasses the assets in the equity market is the most objective.4 The RNJEI series provides comprehensive coverage of the Japanese equity market, as the indexes include stocks from both the First and Second sections of the Tokyo Stock Exchange, as well as the JASDAQ and other exchanges.

Free float weighting of equity components, by adjusting for closely held shares that were rarely traded or were owned by other companies (cross-ownership), to reflect how much of each company’s stock was actually available for purchase. (DoCoMo was a classic example of what happens when you do not make adjustments.5)

Careful adjustments for equity availability, including Seiri Post stocks,6 Japanese railroad real estate holdings and state-owned enterprises such as NTT, etc., reflecting unusual aspects of the Japanese equities market. Further, a series of technical adjustments, such as accurate closing prices, listing requirements, etc., were made to accurately measure what really happened to prices and capital flows in the Japanese market.

The Russell/Nomura Japan Equity Indexes were developed to provide broader and more representative coverage of the market than was available with existing Japanese equity indexes.7 In 1995, the existing indexes that were available to measure the broad Japanese equity market were the Tokyo Stock Exchange Price Index (TOPIX), the Nikkei Stock Average (Nikkei 225) and the MSCI Japan Index. The TOPIX included only stocks from the Tokyo Stock Exchange First Section, which is only a portion of the total Japanese equity market. The Nikkei 225 was price-weighted, a weighting scheme that is much less relevant to institutional investors than is weighting by market capitalization. The MSCI Japan Index included only a sample of the largest capitalization companies of the Japanese market.

Subsequently, in 2004, the Russell/Nomura Prime Index was developed, consisting of the 1,000 largest and most liquid companies in the Russell/Nomura Total Market Index. The Russell/Nomura Prime Index provided an even more investable representation of the Japanese equity market than did the Total Market Index. The index was designed for extra-large passive funds. It covered both large cap and small cap markets with 1,000 names, while eliminating the smallest and most illiquid stocks of the Russell/Nomura Total Market Index. The index also introduced a banding methodology to decrease turnover at reconstitution.

In this paper, we look at how these index design choices have resulted in observed characteristics over the last 20 years. We show how elements of the design have affected the index characteristics by comparing the Russell/Nomura Japan Equity Indexes to other indexes intended to represent the Japanese equity market, primarily the market-leading TOPIX. We begin with index returns and see how the RNJEI series has measured key facts of Japanese equity market history. Then we examine the overall composition and weighting of the Russell/ Nomura Total Market Index, and show that it is more representative of the broad market than other indexes.

The information in this paper is not intended to be, or represent, the competitive landscape of the market for Japanese market indexes, nor is it a picture, indicative or otherwise, of market share. In this paper, we focus on the Russell/Nomura Japan Equity Indexes as well as the TOPIX and MSCI Japan Index. Until 2014, all of the Government Pension Investment Fund (GPIF) passive domestic equity investments were allocated to the TOPIX, so it is essential to include in our analysis.8 At the time that the Russell/Nomura Japan Equity Indexes were developed, the MSCI EAFE Index was a widely adopted global benchmark; the MSCI Japan Index included in this analysis is a component of MSCI EAFE Index. We did not include the Nikkei 225 in our analysis as it is a price-weighted index, unlike the Russell/Nomura Japan Equity Indexes, TOPIX or MSCI Japan Index which are market cap-weighted indexes.

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