How Japan's Declining Population Could Affect Your Portfolio

Japan is the third or fourth largest economy in the world, depending on how it’s measured, which means that many international investors have significant exposure. For instance, the Vanguard Total World ETF (NYSE: VT) has 8% exposure to Japan, which is higher than any other country or region outside of the United States and Europe. Despite its large size, the economy faces a growing demographic risk that could jeopardize its future growth.

Let's take a closer look at Japan’s growing demographic problem and what international investors can do to protect their portfolios.

Declining Population

Japan’s population has shrunk by almost one million people between 2010 and 2015, according to official census data. While birth and death rates have long predicted the decline, the 2015 census data is the first time that the declines have been captured in official records. The decline also marks the first time that a developed country has recorded a sustained and difficult-to-reverse (given the lack of immigration) decline in its population.

A declining population poses two problems for the country’s economy:

  • Smaller Labor Force. Nearly a third of all Japanese citizens were over 65 years old in 2015 and that number is expected to jump to 40% by 2050. With so few workers, the 21st Century Public Policy Institute projects that the country’s GDP could shrink to one-third the size of India and one-sixth the size of China by 2050.
  • Greater Public Expense. Japan’s public finances could suffer as its population ages since it will have to grapple with rising healthcare and pension costs. With these growing costs, the country’s debt-to-GDP ratio could grow to 416% by 2050 and 656% by 2011, assuming no growth or yield on government debt.

    Japan could remedy the situation by easing immigration restrictions in order to draw in younger working age citizens, but it would be a politically unpopular move in the current climate. Additional measures could also be taken in order to encourage couples to have children, but again, there has been little political willpower to implement these changes. And, it’s uncertain whether or not these trends can be reserved or if they represent a ‘new normal’.

    Positioning a Portfolio

    Japan’s demographic problems have led many international investors to reduce exposure to the country. While market capitalization weighted indexes must assign a large weight to Japan by definition, actively managed funds that build their own portfolios are free to reduce their exposure to the country. This approach might make sense for institutional investors that have multi-million dollar portfolios, but individual investors may have a tougher time adjusting.

    Individual investors that want to reduce their exposure to Japan have a couple different options. First, they can avoid buying exchange-traded funds (“ETFs”) with exposure to Japan, although it can be hard to find broad international ETFs without such exposure. For experienced investors, put options can be used on Japanese equity ETFs as a hedge to offset risk. And finally, ETFs that use alternative weighting mechanisms may also be considered.

    It’s also worth noting that some of these risks will be self-correcting over time. As Japan’s economy contracts, it will account for an increasingly smaller portion of international ETFs that are weighted by market capitalization. While investors may suffer from the declines over time, the other benefits of using a cheap passively-managed index fund may outweigh these costs given that the country currently accounts for less than 10% of the portfolio.

    The Bottom Line

    Japan is one of the largest economies in the world, but it’s aging population poses a significant long-term risk. The country’s economy could suffer from a dangerous combination of less economic output and rising debt. International investors can hedge against these risks by building their own portfolios without as much Japan exposure, purchasing put options on Japan equity indexes, and looking into ETFs that uses alternative weighting mechanisms.