ETF providers’ interest in Japan’s equity market is rising thanks to fresh monetary stimulus and increased demand from government-linked investment entities.

Alongside the central bank’s decision to pump money into exchange-traded funds, the country’s largest pension fund has significantly increased its inflows into domestic stocks.

The inflows could now start to accelerate as Japanese institutional investors follow suit, which has encouraged international ETF providers to create products to compete with local firms in a market that has been generally insular.

During two decades of economic malaise and equity underperformance, most foreign institutional and retail investors ended up staying away from Japanese stocks.

But two noteworthy decisions last year marked a sea-change in that trend.

Bank of Japan governor Haruhiko Kuroda surprised the market on October 31 when he announced record stimulus. The central bank pledged to increase Japan’s monetary base by ¥80 trillion ($668 billion) per year, tripling its annual investment into ETFs to ¥3 trillion (in part to avoid a perception of playing favourites with local firms).

Just days beforehand, Japan’s $1.3 trillion Government Pension Investment Fund (GPIF) revised its policy mix and asset allocation effective from October, increasing its maximum allocation to domestic stocks from 18% to 34%.

This could see as much as $460 billion flow into the equity market, forecast Deutsche Bank in its annual ETF review. GPIF does not disclose its ETF target, but it is understood to be a major purchaser.

“Even if a small portion of this flow is going to ETFs it would mean billions of dollars in inflow,” the report states. “We expect Japan ETFs to attract significant inflows in 2015.”

The understanding is that Japanese institutional investors, particularly pension funds, will follow suit. Japan ETFs attracted inflows of $14.8 billion last year, a step up from the $14.2 billion in 2013. Deutsche expects that trend to continue.

Moreover, the introduction of the Nippon Individual Savings Account (Nisa) tax-free scheme in January last year could give ETFs a retail boost. The programme is designed to encourage more active securities investment by dormant Japanese households and has resulted in increasing ETF use, market-watchers note.

These moves have encouraged international ETF providers to move into locally listed products in Japan – a market dominated by Nomura Asset Management, Nikko Asset Management and Daiwa Asset Management.

BlackRock’s iShares listed an ETF based on the JPX-Nikkei Index 400 in December, a new index that sets inclusion requirements for companies, such as a three-year average return on equity of 40% and a three-year cumulative operating profit of 40%.

In announcing their allocation changes, both BOJ and GPIF have added the JPX-Nikkei 400 as a benchmark index.

“There is genuine demand [for the ETF],” said Susan Chan, the head of the iShares business in Asia. By the end of last year BlackRock’s new Japan ETF had attracted $235 million in AUM, according to Deutsche Bank data.

Almost all the demand came from Japanese institutions, although BlackRock declines to identify them. The US fund house is hoping to benefit as a source of diversification for large institutions keen on avoiding an overconcentration in one provider’s ETFs.

Swiss bank UBS also listed 10 ETFs in Japan in mid-March. Seven are devoted to European stock markets, with products tracking indices such as the Euro Stoxx 50 and FTSE 100. Previously the only Europe-focused ETF in Japan had been a Russian ETF from Nomura AM.

But not all providers are keen. Deutsche Asset and Wealth Management’s db X-trackers has extensively cross-listed its European ETFs in Hong Kong, looking to target North Asian clients, and in Singapore, its beachhead for Southeast Asia.

It focuses on global ETFs as well as products focused on Europe, the Americas and the broader Asia-Pacific market in what it calls a “supermarket approach”.

It has already won regulatory approval to list some of its ETFs in Japan, but has chosen not to do so at this stage. In all, 73 of its products are ready for listing if the German bank chooses to go down that route.

“When you look at the distribution of assets under management of ETFs listed in Japan you can observe a very strong local bias towards Japanese underlying,” said Marco Montanari, the bank’s head of passive asset management for Asia Pacific.

Some investors also aren’t interested in Japan-listed ETFs. “We prefer the currency hedged ETF currently offered by Wisdom Tree,” said Tama Churchouse, a partner at the Churchouse Publishing family office.

“It’s hard to make a case for being long the yen right now, and there’s a good chance we will see another round of easing from the BOJ in the next few months, which should support equities and pressure the yen, as it has in the past.”

For the full feature on Japan's ETF market, see the current (April) edition of AsianInvestor magazine