12 October 2021

Remember to dig beneath the surface

Is the FTSE 100 a good investment? Brian Tora explores some of its complications below.

I am old enough to remember when the benchmark index for the London Stock Exchange was the FT Industrial Ordinary Share Index, comprising just thirty shares. In those days it wasn’t weighted for market capitalisation, but it was all we had, so we took it as our guide to how markets were behaving. But in 1984 it was superceded by the FTSE 100 Share Index, which became known as the Footsie. Often described as representing the 100 largest companies in the UK by market capitalisation, it is universally accepted as the principal benchmark for the London market.

Like so many aspects of the investment world, understanding the Footsie is not quite so straightforward as you might expect. For a start, there are not always 100 shares in this index, though the number will always be close to this target. As an example, when first launched 101 companies were included, while takeovers can remove a constituent between the quarterly review periods.

Then there is the fact that it is not necessarily the 100 biggest companies, but rather 100 of the 110 largest. Fall to 111 in the market capitalisation stakes and you are on the way out; rise to number 90 or above and you should be automatically included. But between 91 and 110 there is a degree of discretion afforded to those whose job it is to determine the make-up of the index.

This can be useful at times of extreme market volatility. During 1999 and 2000, at the time of the so-called TMT boom (Technology, Media and Telecommunications), when the tech bubble inflated – only to burst three months in to the start of the new millennium, technology-based companies were entering the index in droves, forcing out constituents belonging to old fashioned legacy industries, only to be dropped later as market valuations imploded.

This serves to demonstrate how this index can be mightily affected by the fortunes of specific industries. In the run up to the financial crisis of 2008, the Footsie was dominated by the financial sector, most notably banks. The bear market of 2008/09 was led by the collapse in banking shares. Subsequently, poll position was assumed by resource companies – the miners and oil majors – though these have proved notoriously vulnerable to the vicissitudes of the global economic cycle. Resource stocks, financials and pharmaceuticals continue to play a very large part in the performance of this index.

Looking at these important industries perhaps explains why the performance of the FTSE 100 Share Index relates more to global economic conditions than domestic circumstances. Around 70% of the revenue of this index derives from sources outside the UK, with the US dollar providing the most important source. Thus, the index is particularly sensitive to what is happening to sterling on the foreign exchange markets, especially when it comes to its relationship to the dollar. While this might be considered a plus in times of domestic uncertainty, it doesn’t seem to translate into better performance.

What is sadly lacking in the current constituents of this important benchmark is technology. True, the main technology giants are US corporations, with south east Asia, most notably China, throwing in more than a handful of global champions, but it does go some way towards explaining why the Footsie has comprehensively underperformed the leading US indices. Indeed, it has lagged the all-world indices and even the more domestically focussed FTSE 250 Index.

Part of the reason could well be that there are many smaller high growth businesses in this index, including a sprinkling of technology companies, so the greater focus on the domestic market is less of an issue. It is, of course, a potentially more volatile index, but if it delivers for the longer-term investor, should this be a concern? It does beg the question as to whether the FTSE 100 Index should really be the investment of choice for the risk averse equity investor.

With so much of investors’ capital flowing into passive index trackers these days, deciding which index to back has become an important decision. There has been considerable speculation as to whether the Footsie is due to play catch up. It is, after all, more than 10% below an all-time peak achieved over three years ago, while many other indices, including America’s S&P 500 and our own FTSE 250 have reached new highs much more recently. But digging deep makes me sceptical that this is likely to happen.

A retired investment banker friend, who is a particularly successful personal investor, is often asked where to invest. His answer is always to buy an index tracker, yet he seldom uses them himself. His contention is that few private investors have the capability or resources to undertake the type of research that is needed to make good stock picking decisions, so index tracking is a safer solution. But for me it just reinforces my view that carefully chosen active funds are the best option.

Brian Tora, Associate

Bespoke Discretionary Portfolio Management

Discretionary Portfolio Management

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