These trackers could enjoy a stronger recovery than the wider market.
Which stock market-index is set to benefit most from an economic recovery, assuming that one is somewhere around the corner? It's a question I've been pondering and one that has led me to some interesting -- and hopefully profitable -- conclusions.
To some, the question might come as a surprise. Many novice investors, for example, think that the main UK market indices broadly rise and fall together, providing little opportunity to gain by investing in one particular index at the expense of another. Not so.
Tracker basics
First, let's briefly review the basics. There are three major indices that represent the health (or otherwise) of the UK stock market. First, there's the FTSE 100, which comprises the hundred largest companies by market capitalisation. Second, there's the FTSE 250 index, which contains the next 250 listed companies below the FTSE 100. Third, there's the FTSE All-Share index. This is a basket of 600 or so shares and is intended to represent the entire main London market.
Here on The Fool, we've long argued that index trackers are a low-cost, low-risk way of investing in the stock market. You're investing in a basket of shares, not just one or two -- so the risk is spread -- and the typical tracker costs a lot less than the typical investment fund.
Many investors have opted for trackers that follow the FTSE All-Share -- because rightly, in my view, they have regarded the FTSE 100 as too heavily weighted towards banks, insurers, oil and gas giants, and mining companies. Legal & General's flagship UK Index FTSE All-Share tracker, for instance, has been going since 1992, is one of the biggest trackers in the market, and has annual charges of just 0.52%. Exchange-traded funds (ETFs) offer another route to buying the FTSE All-Share index, and are growing in popularity.
As the economy picks up, the stock market should recover from the headlong plunge that has seen the FTSE 100 contract by 48% between June 2007 and March 2009. April, for instance, saw the market rise by 8%, and we've seen further gains since then. But those gains haven't been evenly spread -- and won't be, going forward. Which, in my view, offers canny investors at least three interesting alternatives to the FTSE All-Share index.
Blue-chip buy
The first is the FTSE 100 index. All the reasons to avoid the FTSE 100 index in the past are now reasons for buying into it -- provided, of course, that you also buy into the logic that having been disproportionately hammered, then miners, oil companies, banks and insurers are poised for a stronger-than-average recovery.
Already, based on Friday’s closing prices, banks such as Royal Bank of Scotland (LSE: RBS) and Lloyds Banking Group (LSE: LLOY) are up 131% and 171% respectively from their lows in March. Among the miners, Vedanta (LSE: VED) is up 124%, while Anglo-American (LSE: AAL) is up 62%. Because of weakness in other sectors, such as pharmaceuticals, the strong rises in finance and mining shares has yet to filter through entirely to the FTSE 100 itself: it's grown by 'just' 21%.
Mid-cap choice
Now let’s turn to another opportunity -- the FTSE 250. Again, because it is subject to the same broad economic forces, it moves roughly in the same direction as the FTSE 100 and FTSE All-Share indices. But because it's made up of smaller companies with a higher potential for growth, over the longer term it’s capable of growing much faster than the other two indices.
Look at the numbers. From the low point of the previous downturn in March 2003, the FTSE All-Share and FTSE 100 had climbed 118% and 105% respectively by June 2007. Yet the FTSE 250 had soared by a much more impressive figure -- a whopping 221%, more than twice the growth achieved by the FTSE 100, and almost twice the performance of the FTSE All-Share.
And already, since the beginning March, while the FTSE All-Share has climbed 22% and the FTSE 100 by 21%, the FTSE 250 has powered its way to a rise of 29%. And those gains were based on Friday’s closing prices, before today’s rises of 3% or so following a strong rally on Wall Street yesterday while British markets were closed.
Dividend basket
Thirdly, here's a much more intriguing index-related recovery play, which is currently being discussed by Fools on one of our discussion boards.
A popular ETF among investors has been the iShare Dividend Plus (LSE: IUKD), which represents a basket of 50 high-yielding shares drawn from the FTSE 100 and FTSE 250 indices.
Prior to mid-2007, when the credit crunch began, the iShare IUKD ETF grew strongly, while continuing to deliver a steady stream of dividends. But many of those dividends came from companies such as Lloyds Banking, RBS, and similar assorted credit-crunch casualties. The result: IUKD has underperformed not only the broader market, but also the FTSE 100 as well.
As such -- if you buy into the proposition that these former high-yielding stocks are due for a rebound -- then IUKD represents a bunch of shares poised to deliver superior returns when the stock market recovers. Well that's what the Fools on our iShares & ETF board think, and I'm inclined to agree with them.
Malcolm Wheatley owns shares in Lloyds Banking. His delightful wife Mandy has Legal & General’s UK Index tracker in both her ISA and SIPP. You can join her through the Motley Fool's Index Tracker centre. Monthly contributions can be as little as £50.
