Should you buy the FTSE 250 index instead of the FTSE 100?

Investing in ETFs, or exchange-traded funds, can be a great way to access the stock market.

By buying an index ETF, investors are able to purchase the equivalent of a diversified basket of shares through their trading platform in just minutes. The process is simple and generally much cheaper than buying traditional mutual funds.  

Looking at the most popular ETFs in the UK, there’s no doubt that most investors take a rather vanilla approach to investing and buy an ETF that tracks the FTSE 100 (FTSEINDICES:^FTSE).

Given that the FTSE 100 contains the 100 most highly capitalised companies in the UK, this is a sensible choice for investors seeking secure, long-term returns.

Yet to my mind, the FTSE 100 has been a disappointment in recent years. With key stocks such as HSBC, Lloyds Banking Group, Royal Dutch Shell and BP having struggled for growth, the FTSE 100 has returned a rather poor 2.83% over five years and just 3.63% over 10 years.

Add in the reinvestment of dividends and the figures improve dramatically to 23.78% and 50.07%, illustrating the importance of dividends. But still, this performance is hardly spectacular.

Need for speed

And that’s why today I’d like to introduce you to a faster growing index – the FTSE 250 (FTSEINDICES:^FTMX).

Think of the FTSE 250 as the little brother to the FTSE 100. The index is made up of the 250 highest capitalised stocks outside the FTSE 100. That’s an important concept to grasp – it’s not the 250 highest capitalised stocks in the UK, but the stocks ranked 101 to 350 in terms of market capitalisation.

Consequently, this index has a completely different risk and return profile to the FTSE 100.

Exciting growth opportunities

Whereas the FTSE 100 is full of mature blue chip companies such as HSBC, Royal Dutch Shell and British American Tobacco, the FTSE 250 generally contains mid-cap and small-cap companies with much higher growth potential.

FTSE 250 names include companies such as house selling platform Rightmove, kitchen specialist Howden Joinery Group, cyber security firm NCC Group and packaging specialist DS Smith.

Obviously, an index made up of smaller companies is likely to be more volatile than a blue chip index. Yet I believe the rewards are well and truly worth the risk. Looking at the long term performance of the two indexes, there’s no doubt that the FTSE 250 has completely smashed the FTSE 100 in terms of total return over a five and 10 year period. 

Over five years the index has returned 39.85% and over 10 years the return is an impressive 70.08%. Throw in the reinvestment of dividends and these figures jump to a huge 60.45% and 123.87%.

Can you afford to miss this kind of growth in your portfolio?

Diversification Benefits

Another key benefit of investing in the FTSE 250 is the diversification benefits the index offers at both stock level and asset allocation level.

At stock level, the index is split over 250 stocks meaning that there’s less chance of one or two key stocks dragging the index down.

At an asset allocation level, investing in this index alongside the FTSE 100 results in a portfolio that covers a wider range of stocks and should be able to perform well, no matter whether large- or small-cap stocks are in favour.

Ideally, a diversified portfolio would contain both indexes – combining the stability and high dividends of the FTSE 100 with the extra growth potential of the FTSE 250.

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Edward Sheldon owns shares in Royal Dutch Shell, NCC Group, DS Smith and Howden Joinery Group. The Motley Fool UK owns shares of NCC. The Motley Fool UK has recommended BP, DS Smith, HSBC Holdings, Rightmove, and Royal Dutch Shell B. We Fools don't all hold the same opinions, but we all believe that considering a diverse range of insights makes us better investors.