|
|
|
Wealth Management 2005 from
|
|
The increasing risk of index trackers
" By Tim Childe
Executive director and head of Jersey branch, Morgan Stanley Quilter
FOR much of the past 30 years the investors in UK equities were able to benefit from the unusually wide range of companies listed there. With ample access to good investment opportunities both in the UK and abroad provided simply by investing in a wide range of UK listed companies, following an index-tracking strategy became very popular. But as ever, the game has moved on. The UK market is becoming less and less suited to passive investment and investors in UK trackers would do well to take note.
So if you are one of the millions who invested in a UK tracker fund since the mid-Nineties what do you need to know and, more importantly, what do you need to do? Well, first the good news: you made a good choice originally. Compared to the more ‘exciting’ options offered at the time you have probably done quite well.
But what you bought and what you own are not the same. While many professional and internationally aware investors have large developed work-arounds to avoid the pitfalls specific to UK index trackers, many private investors still take comfort in the original sales patter. While the professionals and institutions have increased overseas investment, invested in private equity, property and hedge funds, and have requested new indices where 5% would be the largest holding, the smaller investors have done nothing.
Index funds use the market capitalisation of each company to determine the percentage of your investment they will invest in each stock. This approach seems sensible in that in general large companies might be assumed to be more mature, stable enterprises. But it has limitations and can lead to some bizarre effects.
We can see this in Table 1 (below) which uses FTSE World Index data to show that how much an indexed investor should have in a sector depends simply on their nationality! A Japanese investor apparently has virtually no need of resource stocks and should be happy with 1.3% but a UK investor needs 25.0%. A UK investor can sleep easy with 0.4% in information technology but a US investor needs 14.1%. It makes no sense – but it is a fact.
The problem is that the indices are based not simply on size but on the size of the companies that happen to be listed in that market at the time. In the UK resource stocks happen to be rather well represented at the moment. There are the two major global oil companies, Royal Dutch Shell and BP, and a string of global mining and smaller oil companies. Some of these have long been listed in London, which also happens to be a leading centre of mining finance, but others have arrived in the last decade. That all are benefiting from the explosive growth in demand for minerals to fuel global growth and the China boom is undeniable.
London’s success in attracting companies to list there, the success of the older companies and current enthusiasm for the sector have had a marked impact on how much money an index fund investor would allocate to UK Resources. Table 2 (below) shows that over the last 20 years the weight of the sector in the more widely used FTSE 350 Index has risen from 11.4% to 23.3%! (The difference between the FT World and the FT350 index weights shows how not all indices are equal). The latest sharp rise is due not only to the rising oil price but also to the restructuring of Shell and Royal Dutch that saw the weight of Shell (now Royal Dutch Shell) rise over 4% to 8.1% of the index. BP’s acquisitions of ARCO and Amoco had a similar impact in the late Nineties. In fact, new issues, mergers, changes to listing rules, changes to indexation rules all impact index trackers. This is investment?
Table also shows that in 1985 a FTSE 350 Index fund would have invested 22.5% in UK manufacturing and industrials (basic industries, general industrials and cyclical consumer goods). Today, that would be only 6.0%. You might argue that UK industry has declined in importance over the period so 6.0% is about right. We might agree, but surely that was an argument for having a lot less that 22.5% in 1985 and not indexing?
Anomalies abound. Despite a 20-year consumer boom, the building of millions of square feet of new shopping space and the credit boom the General Retail sector has shrunk from 8.4% to 2.8%. Banks have risen from 5.0% to 17.6% but despite the fact that it has now intruded into almost every corner of our daily lives information technology has barely changed, rising from 0.5% to just 0.7% – though it did reach 4.5% at the end of 1999.
These changes illustrate how the UK equity market has evolved over the last 20 years. The problem is not that it has evolved but that in doing so a few sectors have become unusually large which gives investors a problem: they no longer hold a diversified portfolio.
And as diversification falls so the risk of holding an indexed portfolio increases. If the positive trends driving, for example, the resources sector continue this increased risk will be good news because the excess exposure will generate more gains. But when the trend reverses the opposite will be true and large losses will result. This is exactly what we saw with the TMT bubble.
At stock level risk has also increased. A number of highly successful global companies are listed in London. Because of their global operations they are many times the size of domestic companies and index funds invest in them accordingly. This means that although the index contains enough companies in enough industries to construct a well-diversified portfolio you will not get one. Some 50% of your money will be invested in the largest 14 companies, with nearly 21% in just three. Two holdings, both similar oil companies, will each be over 8%. A decade ago the largest stock was still under 4.0%. Once again the risk this introduces may work for or against you – but is something you neither want nor need.
With risk at UK market, sector and stock level high by historic standards institutions have sought to reduce it. The most conventional route has been to reduce UK equity and increase international equity. This makes considerable sense because we move from a situation where we are investing in the limited selection of global companies that happen to be listed in the UK to a huge range of global companies listed globally.
Yes, exposure to currency fluctuations increases, but surprisingly little given the international nature of the existing investments. And the wider choice of global companies and wider choice of sectors to invest in substantially offsets this. Just note how much more diverse the world index is in Table 1. For active investors in particular, the ability to substitute a global US or European company for a UK listed equivalent is a must. Where a global company is listed should not set your investment strategy.
Seeking to reduce volatility in particular, institutions have also increased their investment in property, reversing not only the trend by companies to lease rather than own their own properties but also a decline in direct stock market exposure from 2.7% to 1.8% over the last 20 years.
Finally, there is the trend back to active management. This is represented by the rapidly growing private equity and hedge fund industries. Neither are completely new industries, with the role of the former previously carried out by stock market listed acquisitive conglomerates and corporate raiders, and the latter by active fund managers and investment bank trading desks.
Over the last two decades the UK equity market has seen significant structural change. Sector and stock level risk has increased markedly from historic levels. While the local investor will remain largely blind to this, international investors should use the UK market for what it can provide – focused rather than general exposure.TXT
|
|
|
|
