The Motley Fool

Is the FTSE 250 a better investment than the FTSE 100?

Over the last five years, the FTSE 250 has risen by 84%, while the FTSE 100 is up by just 36%. This may lead many investors to decide that the FTSE 250 is a better index in which to invest, since it offers the potential for faster growth.

This viewpoint is backed up by the fact that the FTSE 250 contains smaller companies than the FTSE 100. Historically, smaller companies have offered faster growth rates than their larger counterparts, because they tend to be younger or else offer the scope to expand into more regions and/or product lines than their larger peers. Furthermore, larger companies are often more expensive than mid-caps because of a premium that investors are willing to pay for their lower risk profile.

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Just add uncertainty

However, since the EU referendum the FTSE 100 has outperformed the FTSE 250 by over 5%. This reflects the added uncertainty that has dominated investor sentiment since 23 June. The FTSE 100 contains more geographically-diversified companies, which are less reliant on the UK for their future growth. Therefore, they have become more popular, while the more UK-oriented FTSE 250 stocks have become less so.

In terms of their future performance, it seems likely that the FTSE 100 will continue to outperform the FTSE 250 in the short run. That’s largely because of Brexit. The UK government has not yet invoked article 50 of the Lisbon Treaty and already there is fear among investors regarding the future prospects for the UK economy. Once negotiations start next year, this fear could intensify. And when the UK goes it alone in 2019, it could get even worse.

In this situation, the FTSE 100’s lower risk profile, higher dividend yield (3.7% versus 2.6% for the FTSE 250) and larger companies will naturally have more appeal versus their FTSE 250 counterparts. Therefore, it would be unsurprising for the FTSE 100 to continue its recent rise. That’s especially the case since many of its constituents report in sterling but operate abroad and so will benefit from weaker sterling.

Excellent long term prospects

However, in the long run the FTSE 250 could continue to outperform the FTSE 100. Although it offers a higher level of volatility and a lower income yield than the FTSE 100, it may also provide higher growth rates. Certainly, the UK economy is forecast to grow only marginally in 2017 by the Bank of England. But beyond next year, FTSE 250 companies may benefit from a looser monetary policy as well as greater planned investment by the government in the UK economy.

Of course, both indices offer excellent long term prospects. However, given the uncertain outlook for the UK economy and for sterling, the FTSE 100 is the better buy at the present time. The FTSE 250 seems likely to outperform it in the long run, but over the next couple of years the lower risk, greater diversity and higher yield of the FTSE 100 should prove popular with investors. This should push its value higher at a faster pace than that of the FTSE 250.

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Peter Stephens has no position in any shares mentioned. The Motley Fool UK has no position in any of the shares mentioned. We Fools don't all hold the same opinions, but we all believe that considering a diverse range of insights makes us better investors.