The Japan equity market’s fall from grace in the two decades following the excesses of the 1980s bubble is well documented. One clear trend occurring over the past decade has been a large‑scale shift to passive investment strategies – coinciding with a sharp decline in active investment and supporting sell‑side research. 
This diminishing availability of local research has recently dovetailed with a period defined by significant secular change, both locally in Japan, and globally – change cutting across economic, financial market, political, and societal dimensions.
While not isolated to Japan, investors are also increasingly demanding insights into any heightened ESG (environmental, social & governance) risks – and opportunities – of companies. Investors in passive strategies who want to understand more, or who want to influence positive change in company behaviour or activity, can be constrained in actively engaging with portfolio holdings.
Many large passive Japanese equity strategies are run by global investment managers with limited or no local research presence. This means engagement with companies is imperfect at best, reactive or absent at worst. Meanwhile, the ability to be selective and single out progressive companies with strong or improving ESG standards is an opportunity being lost.
Japan’s evolving ESG landscape
We believe successful investing demands an investment process actively seeks to identify sustainable companies positioned on the right side of change. This is particularly relevant in Japan – a market is experiencing considerable change, with an evolving corporate landscape and where companies are rapidly embracing ESG best practices, particularly under the influence of government initiatives and the demands of local pension funds.
One of the most significant achievements of prime minister Shinzo Abe’s ‘Abenomics’ economic revitalisation strategy has been an improvement in Japanese corporate governance standards. These have, in turn, increased the emphasis on delivering higher returns for shareholders. New stewardship codes, for example, have been implemented with speed and determination, with tangible changes in corporate atmosphere.
Change implies active management and investment selectivity, both to optimise returns and to manage the risks emerging as companies find themselves on the wrong side of change and evolution. This is true today more than ever with respect to ESG considerations, which we believe can only be fully understood by active engagement backed by real, face‑to‑face interactions with company management teams.
In contrast, the fundamental business model of passive management inherently involves a low‑cost solution executed via investment in every company in a particular index. This lack of selectivity, in a world increasingly focused on ESG factors and judgments about long‑term sustainability of business models and practices, seems imperfect. This is especially the case in a market such as Japan, where corporate governance standards are evolving more rapidly than in any major developed market.
Increasing demand for ESG
Over the past year, we have discussed increasingly specific and complex ESG integration and exclusion requirements with clients, particularly larger institutions. Dialogue often emphasises concerns around corporate engagement or the application of negative ESG screens. Most frequently, it focuses on the requirement for ESG factors to be embedded within the investment process, alongside the analysis of traditional financial data points.
This is important from an investment process perspective, but also in terms of how it is shifting the investment opportunity in Japanese equities. To regard these concerns as transient would be an error, in our view, given the rapid adoption of ESG policies and the commitment of asset owners to influence corporates to the betterment of society.
While improvements in corporate governance have served to lift shareholder returns in recent years, the next stage of prime minister Shinzo Abe’s reform agenda focuses on addressing workplace diversity. Here again, the commitment to change is real and progressive.
Workplace diversity and the representation of women in senior management, in particular, are being given explicit focus and attention by a government that sees female workforce participation as a solution to Japan’s demographic shrinkage. These are topics we will continue to engage with Japanese companies going forward in order to fully understand the dimensions of change – and the impact on performance – on a stock‑by‑stock basis.
Tremendous progress has been made in Japanese corporate governance in recent years. This focus on improvement will only gather pace, creating both risks and opportunities for companies as they respond to, or fall behind, the pace of change.
Archibald Ciganer is portfolio manager of the T. Rowe Price Japanese Equity fund. The views expressed above are his own and should not be taken as investment advice.