Japan’s Topix stock index is poised for its biggest overhaul, with more than 600 companies — over a third of its constituents — likely to be gradually removed under new eligibility rules, according to analysts’ estimates.

Companies whose free-float market capitalization ranks in the bottom 3% of Tokyo Stock Exchange-listed firms in August will be phased out of the benchmark over two years beginning in October. That could trigger a scramble among smaller firms this month to avoid being selected for removal.

Ejection from the index would cut companies off from an estimated $1 trillion tracked by passive funds that follow the benchmark Topix, potentially weighing on their share prices. The overhaul addresses long-standing investor criticism that the benchmark includes too many small and illiquid stocks, making it costlier and more cumbersome to replicate.

Analysts estimate companies with a free-float market capitalization of well over ¥40 billion ($252 million) will likely survive the review, though the cutoff will depend on market performance during August.

“Companies, particularly those close to the cutoff, may try to appeal to investors by announcing measures such as dividend increases or share buybacks,” said Chizuru Morishita, a researcher at the NLI Research Institute.

Seika Corp., a trading firm, said the planned Topix overhaul helped spur its decision to announce a ¥3 billion share buyback in May, its first in five years.

“We believe we’ll be above the cutoff for index inclusion but we’ll be watching closely to see whether companies closer to the threshold announce measures to improve their chances,” said Masaki Uchimura, deputy manager of IR at Seika.

Akemi Hatano, a senior quantitative analyst at Mizuho Securities, said some investors are probably already shorting small-cap stocks expected to be removed from Topix after the group underperformed larger peers. “There could be short-covering if companies widely expected to be removed manage to remain in the index,” she said.

The Topix Small Index has gained 17% since the end of March, lagging the Topix 100 Index’s 13% rise.

While hundreds of companies may be removed from Topix, some of the largest firms listed on the TSE’s smaller markets will be added to the benchmark.

The bourse will also begin annual reviews from 2028, allowing companies removed this year to rejoin the index if they improve their free-float market capitalization ranking.

Another objective of the overhaul is to encourage more companies to raise their market value in a bid to qualify for Topix. Japan Exchange Group Chief Executive Hiromi Yamaji reiterated that message last month, urging companies to enhance corporate value by improving profitability and strengthening investor dialogue.

Fumihiko Maekawa, a fund manager at Asset Management One, said the planned removals will weigh on many small-cap stocks, but also create investment opportunities as some companies step up efforts to raise their market value.

“Even among companies removed from the index, some are likely to adopt a more shareholder-friendly stance by improving return on equity, reviewing capital allocation or increasing dividends,” he said. “Many younger companies, in particular, view Topix inclusion as a management priority.”

Written by: Hideyuki Sano — With assistance from Momoka Yokoyama and Yasutaka Tamura @Bloomberg

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