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The Hidden Nasty in Your FTSE 100 Tracker

I can understand the allure of a passive investment vehicle such as an FTSE 100 (FTSEINDICES: FTSE) index-tracking fund.

Heck, it’s hard work researching and monitoring investments in individual companies, and any one company could perform badly. For safety, the argument goes, we should diversify by investing in several firms. The trouble then is that the workload increases, so it’s clear to see the mental leap into the ‘wisdom’ of investing in a passive tracker — diversification is sorted; trading costs are reduced, human error and bad decisions are eliminated, and it gives you plenty of time to sit back, toes in the sand, with a pineapple daiquiri in hand.

What could possibly go wrong? I’ll tell you…

Strong and weak sectors

Companies are not all the same. Some are better than others because they operate in better, more resilient sectors. Some industries remain strong no matter what the macro-economic environment throws at them. I’m thinking of sectors such as pharmaceuticals, consumer goods, utilities, tobacco and food retail.

The companies in those sectors tend to remain steady, generating cash flow and paying dividends right through the full turn of economic cycles: companies such as GlaxoSmithKline, SABMiller and National Grid.

Some industries buckle under the onslaught of wintry economic conditions. I’m thinking of sectors such as banking, financial services, commodities, non-food retail, airlines & tourism and house builders.

Within the FTSE 100, the companies in sectors that are vulnerable to cyclical downturns can buckle at the knees when economies dive, slashing their dividends, often scrabbling for capital to repair their balance sheets, and watching their share prices plummet to astonishing lows — companies such as Lloyds Banking Group, Rio Tinto and Marks & Spencer Group.

Disturbing bias

If you add up the market capitalisations of all the companies in the FTSE 100, the combined value stands at about £1,848bn. However, firms from the cyclical sectors make up around £925 billion, almost exactly 50%, of that figure. That’s a shockingly large weighting to the cyclicals and the hidden nasty in your FTSE 100 tracker.

If I wanted to put together a diversified portfolio of shares that could reflect steady growth over years, perhaps to build up a retirement fund, I’d probably avoid the cyclical sectors and companies altogether. Yet, investing in a passive index following the FTSE 100, whilst offering diversification, forces this overweight participation in the cyclicals. And right now is not the time to invest in cyclicals, I’d argue.

Not to buy and hold

The price-to-earnings ratio (P/E) of London’s senior index is around 14.1 and produces a dividend yield of 3.4%. By conventional interpretation that seems like reasonable value.  But is it good value, at this stage of the unfolding macro-economic cycle, for the 50% of the FTSE 100 index generated by cyclical companies?

Stock markets look ahead, and that means the share prices of cyclical firms look ahead, too. As macro-economic cycles mature and unfold into a period of growth, such as now, cyclical company share prices tend to look for the next occurrence of peak-earnings. That will precede the next cyclical decline into the next economic contraction and falling profits for the cyclicals. Share prices in cyclical sectors tend to discount rising profits ahead of the next profit fall, so we see falling forward P/E ratings and a rising forward dividend yields, often presaging share price and dividend collapse.

It’s a roller coaster not worth riding over long periods and is one reason why cyclical share prices can really drag on the performance of the FTSE 100. As a comparison, the FTSE 250 trades on a P/E of about 19.2, suggesting it might have more embedded growth opportunity and less cyclicality within its ranks.

Stymied growth

With cyclical P/E ratings compressing as we work through the macro-economic cycle, any growth within the FTSE 100 index is up against this drag on upwards progress. I reckon the FTSE 100’s forward performance could be flatter than some other indices.

One thing’s for certain, if the macro-economic environment gets colder, the FTSE 100 is heading down, perhaps more so than some of the steadier, more defensive constituents within the ‘good’ 50% of its ranks. That potential exaggeration of movement makes the FTSE 100 a good vehicle for shorting when you judge the time is right, and for buying at cyclical bottoms, just as is the case for any individual cyclical firm.

The FTSE 100 index is most definitely not an investment vehicle to buy and hold for decades, I’d suggest there are much better index opportunities elsewhere for passive investment.

What now?

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Kevin does not own shares in any companies mentioned in this article. The Motley Fool has recommended GlaxoSmithKline.