Amidst the backdrop of soaring heights in the Japanese stock market, as it reached levels not seen in 33 years, two exchange-traded funds (ETFs) tracking the Nikkei 225 index in China experienced wild fluctuations, plummeting dramatically just days after their share prices surgedThis drastic rollercoaster in prices prompts the question: what is driving this volatility?

On May 23rd, E Fund Nikko Asset Management's Nikkei 225 ETF issued a warning regarding potential premium risks associated with its market performance, reflecting the excessive volatility in the ETF's trading prices on the secondary marketThe notice warned investors to be cautious of the trading price premium that could lead to significant losses if investments were made blindly.

In addition to E Fund, another fund, Huaxia Nomura's Nikkei 225 ETF also released a similar cautionary announcement

Huaxia asserted that the market prices of their ETF, in addition to net asset value fluctuations, are also subject to the influences of market supply and demand, systemic risks, and liquidity risks, which all pose a potential loss for investors.

Both ETFs continued to issue similar warnings across three consecutive trading daysThe first alarm was raised on May 19th, when E Fund Nikko's Nikkei 225 ETF—which had been climbing for six consecutive trading days—saw its net asset value reach a peak, closing up by 10.04%, with a premium as high as 22.44%. Huaxia's version also surged, closing up 8.22% that day with a premium of 17.31%.

A high premium indicates that the trading price of the ETF significantly exceeds its net asset valueIn theory, this situation allows investors to capitalize on a risk-free arbitrage opportunity by purchasing shares of the ETF outside of the exchange and then selling them on the market

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However, in practice, this mode of arbitrage was unfeasible for these two funds.

A report from Huabao Securities pointed out that upon reviewing the subscription and redemption lists of both ETFs on May 19, it became evident that E Fund's ETF had a daily subscription limit of 500,000 shares, while Huaxia's capped at 3 million shares; both required a minimum purchase of 500,000 sharesConsequently, only a select few investors could take advantage of these purchasing opportunities.

This restriction significantly limited the number of participants able to exploit the price discrepancies between the marketplace and off-exchange transactions, ultimately undermining the mechanism that should allow market pricing to be corrected

After the premium risk notifications were issued, the trading prices of both ETFs swiftly dropped

On May 22, while the Nikkei 225 index rose by 0.9%, reaching a record high of 31,086.82—levels not seen since August 1990—E Fund's ETF saw its net value plummet by 9.87%, while Huaxia's ETF dropped by 9.31% on the same day.

The following day brought more bad news, with the net value of E Fund's ETF falling by another 7.48% and Huaxia's by 5.13%. After just two trading days of decline, their previously high premium levels were almost entirely obliterated.

History suggests that high premium rates for ETFs are typically unsustainableAccording to research by Huabao Securities, since 2020, there have been 47 instances where the premium for listed ETFs in China exceeded 15%, yet these high levels were only maintained for an average of 1.7 days

This implies that on average, above-normal premium rates tend to converge back down within a span of no more than two days

Huabao advised that current investors interested in Japanese stocks should look towards ETFs with premiums in a reasonable range, and momentarily steer clear of those bearing high premiums.

These fluctuations in ETF price and subsequent risks come hand in hand with shifts in the fundamentals of the Japanese stock market itself, which has been pouring with optimism lately.

What are the underlying catalysts responsible for this uptick in Japan’s stock market, prompting a “recovery of the lost thirty years”?

Analysts from China International Capital Corporation attribute the upward trend to massive purchases by foreign investors, attributable to four primary factors.

The first being the 'Buffett effect'. Warren Buffett's recent affinity for Japanese shares has led to a follow-along interest from other foreign investors

Notably, Buffett has benefitted from issuing yen-denominated debt to purchase shares, thereby mitigating risks associated with the depreciation of the yen itself.

Secondly, policy guidance from the Tokyo Stock Exchange has come into playThe exchange recently mandated that companies with undervalued stocks (specifically those with a price-book ratio under 1) must present plans for improvements, leading to a greater focus on capital efficiency and shareholder returns among Japanese companies, which has resonated positively with foreign entities.

Thirdly, the post-pandemic economic recovery is evident, as Japan’s economy reflects the benefits of revitalization efforts in 2023. Additionally, the resurgence of foreign tourists into Japan has provided a further boost to economic performance.

Lastly, considerations regarding asset allocation cannot be overlooked

Given factors like monetary policy and geopolitical risks, foreign investors may have resorted to purchasing Japanese stocks as a fallback optionFurthermore, some investors are anxious about missing out on the current upswing in Japanese equities, prompting them to dive in.

CITIC Construction Investment Securities believes that Japan's stock market's ascent can be attributed to the combination of diminishing Federal Reserve interest rate hike expectations and rising Bank of Japan tightening forecasts, which have drawn a wave of international investment capital back to the Japanese marketThis newfound interest is further bolstered by the recovery of economic activities post-pandemic and the solid performance of companies listed on the Tokyo Exchange amidst a depreciating yen last year.

With these changing dynamics, the Tokyo Exchange has also announced reforms to its corporate governance oversight mechanisms, indicating potential stock buybacks by undervalued companies to bolster share prices