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The Uncomfortable Truth About Your FTSE 100 Tracker

The allure of a passive investment vehicle such as a FTSE 100 (FTSEINDICES: ^FTSE) index-tracking fund is plain to see.

Researching and monitoring investments in individual companies is hard work, and any badly performing company can hurt returns. To eliminate such risks, some say we should diversify by investing in several firms. However, that increases workload, so passive tracker funds seem attractive, at least on the surface.

After all, it’s true that a FTSE 100 tracker reduces trading costs and human error. It also takes care of diversification between companies, right? Well, in terms of the money invested in a FTSE 100 tracking fund that’s wrong, and here’s why…

Replication by weighting

Some companies in the FTSE 100 index are much bigger than many others are. If you look at individual market capitalisations, banking company HSBC Holdings, for example, represents about 6.2% of the index, whereas house builder Persimmon accounts for just 0.2% .

A passive FTSE 100 index tracking fund replicates these company weightings and that situation leads to some disturbing imbalances that work against proper diversification by company for investors.

Such is the skew to the bigger constituents of the FTSE 100 that about 74% of the money we invest in a FTSE 100 tracker goes into just 30 companies. So, the fortunes of the few have a disproportionate impact on the performance of most of the money invested in the fund.

But it’s worse than that. If we look at the biggest 15 companies in the FTSE 100 we can see that they suck up just over 50% of the funds invested in a tracker fund. Taking it a step further, the biggest five companies in the index control around 25% of the funds invested.

So, to invest in the FTSE 100 index is to invest in just a handful of companies, which isn’t immediately apparent when we think of the 100 companies forming the index. It’s the uncomfortable truth about your FTSE 100 tracker.

Where does the money go?

Wait!, I hear you cry. The FTSE 100 looks attractive in terms of valuation right now, doesn’t it? After all, the overall P/E ratio is running at just over 14 and there’s a handy 3.4% dividend yield covered around 2.08 times by aggregate earnings. What’s more, since its credit-crunch nadir during March 2009 at below 3500, today’s 6810 or so means the index has almost doubled in just over five years and now sits about 2% down from its all time high of 6950 achieved in the tech-bubble days of 1999. The FTSE 100 has been doing well, surely there’s more to come.

Yes, the index has done well, but to understand its performance we need to look at the sectors represented by those top 30 companies controlling the majority of money invested in a FTSE 100 tracker fund. This is where the 74% of funds controlled by the 30 firms goes:

Industry Allocation
Oil and resources 33%
Banks and financials 22%
Consumer goods 13%
Pharmaceuticals 11%
Tobacco 7%
Telecoms 6%
Food 3%
Utilities 2%
Supermarkets 1.7%
Engineering 1.3%

So, there’s a massive weighting to financials and resources, two highly cyclical sectors. The cyclicals are ‘supposed’ to do well in the early stages of a macro-economic recovery and they’ve driven the FTSE 100 up in recent years. However, as the macro-economic cycle unfolds, the future performance of the cyclical companies is far less clear and I’d argue that the best time to invest in such firms might have passed for the current up-leg.

What now?

If you are investing in a FTSE 100 tracker it’s probably best to keep a close eye on at least the biggest five firms in the index: banking and financial services HSBC Holdings; oil majors BP and Royal Dutch Shell; pharmaceutical giant GlaxoSmithKline and cigarette producer British American Tobacco. After all, that’s where a quarter of your money will be.

Allocating very little capital to 70 or so companies in a FTSE 100 tracker fund seems like a missed opportunity, as the greatest growth opportunity tends to reside in the lower reaches of the index.

Rather than a passive FTSE 100 tracker, I'm looking at three companies that look set to do well this year. In fact, the Motley Fool's top team of share analysts reckons these three could be among the best picks for the next decade.

One is a FTSE 100 company with some of the strongest long-term growth potential on the entire market, there's a Real Estate Investment Trust with a record of delivering for investors through tough times, and a diverse technology company with decent growth potential

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