Better index fund buy: the FTSE 100 or FTSE 250?

The FTSE 100 and FTSE 250 have both climbed in the last trading week. Paul Summers considers which index might be the best horse to consider backing now.

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Hold the front page! The UK stock market has actually enjoyed some positive momentum in the last week. At lunchtime on Friday, the FTSE 100 index is up around 1.5% and the FTSE 250 is almost 4% higher.

Sure, some single company stocks have posted far higher gains. However, I reckon those investors opting for a ‘slow and steady’ strategy via index funds will still be encouraged.

This got me thinking. Which of a FTSE 100 or FTSE 250 fund might be the better buy now?

Whiff of optimism

Before looking at that, let’s quickly dwell on the main reason behind this week’s uplift in value, namely that cooling inflation has raised hopes interest rates may be reduced.

Knowing a drop may still be months away isn’t the point. Knowing that any reversals may only happen gradually isn’t the point either. As experienced Fools will attest, markets are forward-looking. They buy (or sell) in anticipation of something happening.

But no one knows when that ‘something’ will occur (if it occurs at all). As a result, deciding which might be a better buy depends greatly on one thing I have control over, namely my tolerance for risk.

Big is better?

The FTSE 100 contains our biggest companies, many of which will generate most of their profits from outside of the UK.

Collectively, this market clout and earnings diversification make them relatively safe. Yes, the actual members change over time but the nature of the index doesn’t. We’re still looking at the bluest of blue-chips here.

The FTSE 100 is also pretty generous when it comes to dividends, due to its members being well established. As things stand, an index fund would yield around 4%. That’s not too shabby.

However, this usually comes at the expense of capital growth. In the last five years, the FTSE 100 has climbed a little less than 8%. While it’s not the focus here, the S&P 500 index across the pond is up by over 70%!

One big reason is that the FTSE 100 contains lots of old-economy companies (eg banks and oil giants) where expansion is hard to come by.

Higher growth

Here’s where the FTSE 250 arguably shines brighter. Since their operations aren’t yet so far-reaching or developed, mid-cap stocks have the capacity to grow at a faster clip.

But this greater dependence on the UK economy can be a double-edged sword. Tellingly, this index has failed to match even the lacklustre returns of the top tier in the last five years. The heightened focus on growth (which usually involves taking more risks) also explains why the FTSE 250 typically has a lower dividend yield.

My verdict

As a rule of thumb, smaller companies tend to get hammered harder during times of economic strife. However, the reverse is true when the clouds eventually lift. And I think we’re coming towards the end of this latest storm.

So a FTSE 250 index fund could be a better buy for me going forward.

Then again, I can’t overlook how some seriously high-quality stocks now trade on seriously tempting valuations.

As such, I’m comfortable throwing at least some of my cash into single-company stocks hoping that I can ride a massive market reversal and beat the return from both indices.

Should you invest, the value of your investment may rise or fall and your capital is at risk. Before investing, your individual circumstances should be assessed. Consider taking independent financial advice.

Paul Summers has no position in any of the shares mentioned. The Motley Fool UK has no position in any of the shares mentioned. Views expressed on the companies mentioned in this article are those of the writer and therefore may differ from the official recommendations we make in our subscription services such as Share Advisor, Hidden Winners and Pro. Here at The Motley Fool we believe that considering a diverse range of insights makes us better investors.

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