Exactly What Are You Tracking?

If you think that buying an index tracker gives you a representative slice of the general economy, think again.

If you think that buying an index tracker gives you a representative slice of the general economy, think again.

Although index trackers are the broadest equity products available, they are far more focused than many imagine -- broad exposure to the stock market does not give you broad exposure to the economy. There are several reasons for this:

• Much of the business is outside the UK. Consider the Oil and Gas sector, which makes up only 2% of GDP, but 17% of the FTSE 100 -- most production and sales are overseas;
  
  
• Many industries do not require access to the capital markets. Taxi companies or doctors, for example, are part of the economy, but are not quoted on the stock market;
  
  
• Even many capital-intensive sectors are entirely in private ownership. For example, if Forth Ports is eventually taken over, as is currently being speculated, then there will be no publicly traded port operators;
  
  
• Valuations often bear little relation to the level of economic activity.

Currently, more than half of the FTSE 100 can be accounted for by just twelve companies:

... and just four sectors:

This makes investments in the FTSE 100 particularly sensitive to the dollar exchange rate, the price of oil, and interest rates -- widening the analysis to the FTSE All-Share doesn't change that picture much. That's not necessarily a bad thing, but investors need to understand what they're getting into.

The situation is even more extreme in some other countries; at its peak, Nokia (LSE: NOK) accounted for approximately 3% of Finland's GDP, but two-thirds of the value of its stock market!

But what concerns me even more is the fact that when you buy into an index, you buy the over-hyped and overvalued, along with the bargains. In any index, there are likely to be companies and sectors that are peaking, and as their market capitalisations are at their highest, investors get maximum exposure to these stocks. Indeed hot stocks and sectors are often made hotter by tracker funds' obligation to buy their shares.

Of course, whether stock-pickers, sector traders, and fund managers can sort the wheat from the chaff is debatable -- clearly some get it right more often than others, and they like to believe this is due to skill rather than luck.

I'm not knocking tracker funds; they're a cheap and easy way to invest in equities. However, it's important to appreciate that they're often very focused instruments. If, like me, you're arrogant enough to think you can beat the index, and nerdy enough to enjoy the challenge, then picking individual shares allows you to put the focus where you want it.

More: Perfecting The Index Tracker | Intelligent Trackers

Champion Shares editor Maynard Paton can help you with that challenge -- why not take a free 30-day trial now. For a limited period only, you can get a full year's subscription for only £99!