What is the FTSE 100 for?

Tonally, the recent passing of its 40th birthday has been more mournful than celebratory. Middle age always presents challenges. But such a melancholic lament for the index would probably have shocked its creators, the Financial Times and the London Stock Exchange (LSE), had they known in 1984 that the Footsie would today remain the UK equity benchmark of reference, contain more than a quarter of its original members in some form, and have made a 22-fold return, including dividends, during its life.

Still, the current critique should be familiar. Once a collection of world-leading names, today's FTSE 100 is instead seen as bereft of renewal, a grab-bag of has-been, capital-intensive companies, incapable of genuine innovation or consistently above-average returns.

It is sometimes said that in investing, arguments are just people with different horizons talking to each other. Is that not true of the Footsie, too? Sure, US equities are fresh off a hot streak, thanks to some heavy lifting from its tech giants. But include the reset year of 2022, and there’s little to separate the two-year aggregate returns of major indices, the UK included. 

Head back further towards the start line, and things look brighter. Since the start of 1988 – the point from which the LSE holds total return price for both the UK and US blue-chip bourses – the FTSE 100 has averaged 11.5 per cent a year. That’s short of the sterling-based 15.2 per cent from the S&P 500 over the same horizon (itself flattered by the dollar’s steady rise against the pound), but well above the long-term historic average return from equities.

Then again, for the purposes of divining future returns, it’s questionable how much weight anyone in 2024 should apply to periods in which Vodafone (VOD) or Barclays (BARC) could be considered great stocks to own. Indeed, on most annualised snapshots over the past two decades, headline performance backs up the also-ran thesis (see table).

Until a turnaround occurs, poor performance will only compound negative perceptions.

But we can also dispense with the straw man arguments, the most egregious of which is the endemic flagging of the Footsie’s capital returns in isolation. When it comes to UK blue-chips, to overlook dividends is to ignore their key attractions – price stabilisation and accountability – and the lion’s share of their returns. Over the past five years, the FTSE 100’s annualised simple return is an inflation-lagging 2.2 per cent, or a full 11 percentage points below the S&P 500’s yearly average. But factor in dividends, and the Footsie’s annual total return triples.

While those dividends aren’t enough to close the gap, the index is not entirely to blame for its bigger relative shortcoming, namely its lowly valuation, where the injury is twofold.

First, where it does boast genuine global players, investors are content to sit on their hands. For example, were its two integrated energy giants, Shell (SHEL) and BP (BP.) to be valued on the same forward earnings multiple as Chevron (US:CVX) or ExxonMobil (US:XOM), those stocks would be worth 38 and 56 per cent more, respectively. Given their heft within the index, that would increase its value by roughly 5.5 per cent, or £105bn.

Second, the bald fact is that the FTSE 100 lacks size in the sectors where earnings multiple expansion has been most aggressive. Information technology, which now makes up 28 per cent of the S&P 500 by market capitalisation, is that market’s most highly valued sector, on 25 times forecast earnings for the next 12 months – two-and-a-half times the Footsie’s own multiple.

In other words, this isn’t a like-for-like comparison, even if movements in both UK and US equities markets show both correlation and covariance.

The dynamic also underscores the point that Silicon-Valley-derived returns explain much of the disparity between UK stocks and global (read US) markets. Lately, this pocket of outperformance has been highly concentrated, which isn't necessarily a plus: over two years, for example, the Invesco S&P 500 Equal Weight ETF (US:RSP) has lagged the FTSE 100 by 3.6 percentage points.

A related, but flawed criticism of the market has its roots in a recently established bit of passive investing dogma. Over the past decade, buying or owning the S&P 500 has been so shrewd because its largest constituents have also been its greatest performers. As a result, we have grown accustomed to thinking that from the disparate ingredients that make up an index, the cream will inevitably rise.

However, the Footsie is proof that disparate parts don’t always fit together effectively. The ascent into the top 10th of the Footsie of data analytics group RELX (REL) – which was trading as Reed International, a publisher of magazines and trade books in 1984 – is proof that quality can and will eventually shine through. But the profile of similar-sized UK names such as Diageo (DGE) or GSK (GSK) also shows that less dynamic businesses can take a while to shake out.

The legacy of London’s capital markets is an enduring abundance of miners, banks and insurers at the top of the pile. And to many observers, moving past these ‘old economy’ names is the only thing that can save the index. “The FTSE 100 needs to consist of more companies that come from a technology background,” reckons Mark Makepeace, founding and chief executive of the LSE’s index business, FTSE Russell.

The first response to this should be to ask what benefit such duplication would bring, even if it were possible in the space of a decade or two. Many investors in the FTSE 100 realise its idiosyncrasies and failings but choose to stay in as a hedge against inflation or geopolitical strife. As 2022 showed, the knock-on effects of raised commodity prices and higher interest rates were positive aggregate drivers of the FTSE 100’s earnings, and one of the index’s sources of differentiation against global equities.

Second, we might question the idea that the Footsie’s constituents lack opportunities to embrace change. From ageing and growing populations to building future-proof financial services, national security and the energy transition, software brilliance only gets us so far in tackling our biggest challenges. Do the materials Anglo American (AAL) digs out of the ground offer nothing to the world’s economy of the next 40 years, for example? Then again, megatrends aren't everything. What do the track records of Associated British Foods (ABF) and Whitbread (WTB) show if not the ability of quality companies in apparently tired old sectors to form the bedrock of a steadily compounding portfolio?

What’s more, the embrace of ‘technology’ – often an overly abbreviated short-hand for the internet economy, software and its supporting hardware ecosystem – isn’t a one-way street. If they’re worth anything, the benefits of artificial intelligence (AI) cannot only accrue to Alphabet (US:GOOGL) and Microsoft (US:MSFT). Eventually, the likes of Tesco (TSCO) and HSBC (HSBA) will have to see some advantage, too.

Third, some of the criticism of the FTSE 100 betrays a lack of understanding of capital cycles, which are central to the way economies and successful investing works. The GPUs, software, weight-loss drugs, electric vehicles and cloud computing products of the world’s star stocks may lead to high returns today, but they are also magnets for capital and disruption, raising the risk of oversupply and lower future profit. By contrast, thinning competition in precisely the kind of lower-return, capital-heavy sectors the Footsie specialises in should augur well for the coming years. 

If anything, this reveals a closer parallel between the FTSE 100 and emerging markets, at least in terms of hard assets. Judging by MSCI’s standard index of the latter, the two even share a price to book value of 1.7, less than half the S&P 500’s own ratio. The intangible economy may be ascendant, but centuries of economic history suggest this isn’t the only route to sustainable equity returns.

Lastly, if America is the answer to every corporate strategy – and the best chance of an expansion in price/earnings multiples – then the FTSE 100 is in a reasonable position. The UK accounted for just 21 per cent of the FTSE 100’s revenue exposure in 2023, according to FactSet, with the US slightly ahead at 25.5 per cent. Compare this with the S&P 500, where 59 per cent of revenues are drawn from the US, and it’s clear that for all its world-beating credentials, the US market is much more geographically concentrated.

No one should ignore the Footsie’s anachronisms, or sub-standard record. Equally, investors should avoid zeitgeisty vagaries that tie the index to the UK’s economic decline and stagnation. Better to recognise the function the FTSE 100 might provide in share portfolios, as well as its risk/reward ratio. On the index’s 40th birthday, this sits below one. There may be value here yet.