I am always a little suspicious of the advice to buy index trackers, the FTSE 100 in particular. Here we have an index based on the 100 companies with the highest capitalisation. One would never structure a portfolio in such an unbalanced manner.
Secondly an index that has its failures relegated and replaced by promoting the best-performing shares from the second division, must of necessity record an unreal outperformance, which is misleading, particularly as the index has, apart from oscillations, gained nothing in the past 20 years. There should be an index that is more representative of the proportions of a normal portfolio. Perhaps the top 350 shares equally weighted?
I use a homemade index that started at 50000 and each week I add the number of shares that rise and subtract the number of shares that fall. It has shown a decline over 10 years of 40 per cent, but as it includes Alternative Investment Market (Aim) shares, many of which are transient, this is to be expected. However it is useful to use it to confirm the direction of the popular indices. Many times it has fallen when the main indices are rising, which to me means that the probability of successful stockpicking during these apparent bullish periods is not good.
I conclude that basing one’s decisions on the movement in value of a few very large companies is unsound.
Julian Wade
James Norrington replies: To your overall point about indices, you are correct. Buying a FTSE 100 tracker is, effectively a concentrated play on the fortunes of a handful of very large companies, with the top 10 companies accounting for45 per cent of the index by market capitalisation.
The thing about investing in a FTSE 100 tracker, however, is the total returns – not just capital gains – relative to the risk of the market totally going bust. In the unlikely event that HSBC were to go pop, then the index would suffer a fall, but new companies would join lower down the index, and as these grow the market value of the index will eventually recover. At the dawn of the 20th century, equity markets were even more concentrated than the FTSE 100 – with a huge weighting to railway stocks, which don’t feature in the FTSE 100 today. Buying an index allows investors exposure to the creative destruction of capitalism. In the Credit Suisse Yearbook by Professors Elroy Dimson, Paul Marsh and Mike Staunton of the London Business School the annualised real rate of price returns for UK equities between 1900 and the start of 2019 is 0.8 per cent.
Where it gets interesting, however, is when you consider dividends reinvested and the power of returns compounding, which is what a FTSE 100 total returns tracker will do for you. The Credit Suisse Yearbook has the annualised real rate of total return for the UK market at 5.4 per cent, which is quite a difference. True, the research is based on a broader selection of the market than the top 100 companies at any given time, but on the assumption that the biggest companies have always made the biggest payouts (the top dividend payers in the FTSE 100 pay out the lion’s share of income, about £68bn by the top 20 last year) this exposure is powerful. Although it gives you very concentrated exposure in terms of sectors and industries, buying the index still offers relative protection against total capital destruction (although not against peak-to-trough drawdown when big constituents perform badly) while giving full exposure to income and compound returns.
To your second point about benchmarking, you are again correct. The FTSE 100 is at any given time a play on the fortunes of the biggest companies – even if, longer term, including reinvested dividends, this largely works – so you can only tell if your active picks have done better than HSBC and Shell, not a suitable peer group. One way around this is to use style-weighted indices. These are formulated with a strategy that adds greater weighting to companies that score well on certain concentrated criteria, be they focused on share price or earnings growth momentum, quality or value.
You could take two approaches to constructing such an index, the first would be to just equal-weight the companies that score best on these mechanical style factors and make these the peer group for your actively chosen portfolio. The thing is, all stocks have a beta – the correlation of their price movements with the market, and hence larger companies – so you don’t want to ignore market-cap-weighted performance when you assess which style of investing to focus on.
What professional investors do is create factor scores for all stocks in an index and multiply the market cap weighting of companies by this score to recalibrate the index. The problem for the UK is that, because our stock market is so concentrated in the largest companies, this process doesn’t much move the dial in terms of weighting. A couple of years ago, there was a paper by SG Cross Asset Research that suggested solutions that maintained much of the beta weighting in the benchmark, but tilted the composition of indices so that other style factors were relatively a bigger determinant of returns.
In conclusion, history shows us that it is probably not wise to be totally out of the biggest stocks in the market in favour of smaller companies with different characteristics at any one time. It is, however, worth looking at indices with style-tilted compositions to see which risks are being rewarded in the rest of the market before making further investment decisions.
As an aside, there are many exchange traded funds (ETFs) out there that allow investors to buy into style or ‘factor’ tilts but it might be that when momentum or quality factors are performing best, it is just as well to invest in the market-cap-weighted indices (which are the cheapest products).
We have written on the tech momentum play (Fear the FAANGs, IC, 30 March 2018) that has characterised much of the S&P 500 bull market, so some further issues with concentration in cap-weighted indices are discussed there (although the tech giants aren’t big dividend payers, which means the argument is different than for FTSE 100 Index investing).
