18 March 2019
By Ronan Kearney, Director at Osprey Capital
Responsible for Fund Structure & Governance on the Verbatim Investment Committee
In the first of a series of five articles, Ronan Kearney Director at Osprey Capital and responsible for Fund Structure and Governance on the Verbatim Investment Committee, examines some of the investment assumptions many professional fund managers and advisers take for granted. He raises the questions: Are these investment assumptions justified? Or are there potentially alternative approaches to asset allocation and portfolio construction that could better serve the financial community?
The first question any adviser or investor should ask their investment manager is: Which FTSE 100 do you use for your analysis, and why? It often comes as a surprise to investors, and even to professional advisers, that there is more than one version of the FTSE 100. But should it really be a shock? After all, the FTSE 100 is a manufactured index, owned and licensed by a corporate entity, and product variation is to be expected.
Let’s have a look at the original FTSE 100. Started in 1984, it originally listed companies that generated the majority of their revenues in the UK. Because the stock market was relatively small at that time, it made sense to structure the index on a market capitalisation basis. That is to say, if you had invested £100 it would have been allocated according to the relative value of the companies in the index. A larger company would have more than £1 invested and a smaller company would potentially have as little as £0.10 invested.
In terms of performance, this was a successful model, but over time two disadvantages have arisen. The first is that the FTSE 100 has increasingly become dominated by global multi-nationals that generate the majority of their revenues outside the UK (over 70% at the current time). This makes share price performance subject to changes in exchange rates as well as business performance, arguably adding to the volatility of the index. In addition, three sectors have come to dominate the FTSE in valuation terms, namely Energy, Financials and Pharmaceuticals. Investors therefore have to contend with less diversification and greater exposure to exchange rate risk, both of which add to the risk of their portfolio.
In order to counter some of these aspects, other variants of the FTSE 100 have been published by the FTSE group. In 2011, the first Equal Weight variant was published on a quarterly rebalanced basis, and in 2014 an additional Equal Weight variant was published on a semi-annual rebalanced basis. In 2017 a minimum variance version was also launched. So then there were four!
These additional indices comprise an attempt by FTSE to capture the new investment theory that has driven much institutional thought over the last 15 years, growing to $1,9 trillion in 2018. This is the concept, first published by Ross in 1976, that identified that elements other than size (for example, earnings growth), would drive a company’s share price. This seems obvious to many, but is something that is often missed if you invest in a market-cap weighted index, that allocates your money based solely on company size.
So the question is…which version of the FTSE 100 would you rather own, and does moving the focus away from market capitalisation change anything? Well, it turns out that it does.
In fact, as an investor looking for exposure to UK stocks, an Equal Weight version of the FTSE 100 index would have would have proved to be a superior solution since the turn of the Century, that is to say for most of the FTSE’s actual life
Source: FTSE Russell Factsheet. Data as at: 28 February 2019. Past performance is no guarantee of future results.
However, one key problem remains for retail investors who would like to move their investment approach to take advantage of investment factors such as Value, or earnings Quality by investing in alternative versions of the FTSE….and that problem is that right now they can’t.
Because of the dominance of the Capitalisation Weighted FTSE 100.. ‘the’ FTSE 100, neither advisers nor product providers have considered whether investors would be better served with access to alternative versions of the same index, perhaps with a stronger focus on investment fundamentals – and in our view it would seem that there are potentially alternative approaches to asset allocation and portfolio construction that could better serve investment management that investors should be considering.
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The value of investments and any income from them can go down as well as up and is not guaranteed. Your clients could get back less than they originally invested. Past performance is not a guide to future performance. The portfolios' investments are subject to normal fluctuations and other risks inherent when investing in securities. Verbatim Asset Management has taken due care and attention in preparing this document, which is solely for the use of professional advisers. Verbatim cannot be held responsible for any inaccuracies arising out of information detailed within and will not accept liability for any loss arising out of or in connection with its use. This article is for information only and should not be deemed as advice.