Why I wouldn’t buy a FTSE 100 tracker even as the index hits all-time highs

Buoyed by the Bank of England’s vote of confidence in the domestic economy and a slew of surprisingly strong economic data, the FTSE 100 closed at a record high on Friday afternoon and looks set to beat that performance once again today.

But even with the index at new highs, I’ll be avoiding buying a FTSE 100 tracker fund. This isn’t due to valuations, business cycles or because I have anything against passive investing, in fact the vast majority of my investments are index-tracking ETFs. Rather, it is the top-weighted and highly cyclical nature of many of the index’s constituent companies that makes me uncomfortable.

Large and in charge

One of the advantages of market capitalisation-weighted indices is that they more accurately represent the actual returns of any given market. However, it can also mean a heavy skew towards the larger companies in an index.

This is especially true of the FTSE 100, where the top 10 holdings make up a whopping 43.95% of the entire portfolio as of the end of September, the last period for which Russell has published data. Compared to, say, the S&P 500 where the top 10 constituents make up 20.1% of the entire index, the FTSE 100 looks exceptionally top-heavy to me.

Unrepresentative of the entire economy?

Looking at the top constituents also presents another issue I have with the FTSE 100, its heavy weighting towards cyclical firms with few connections to the UK. For example, the largest constituent is HSBC, followed by British American Tobacco, Royal Dutch Shell and then BP. Four out of these five (Shell’s A and B shares each count separately) are highly cyclical firms that undertake a relatively small portion of their business in the UK and are, in my mind, unrepresentative of the domestic economy.

If we look at the index as a whole, its weighting towards these firms is fairly high with oil & gas shares making up 12.2% of the index and miners a further 6.47%. This skew is fine when these sectors are in the black, but as we saw in 2014 when commodity prices crashed, they can dent the overall index’s returns even as the domestic economy makes forward progress.

It’s hard to find precise data (or at least free-to-access, precise data) on the make-up of the index’s foreign versus domestic earnings. But I think this situation also presents an issue for retail investors who think when they buy a FTSE 100 tracker that they’re investing in a decent mirror of the domestic economy. One of the reasons the index has notched up a year of great returns is that the weak pound has buoyed the sterling-denominated returns of many of the firm’s multinational components.

What’s the solution?

Well, every index has its problems. You could say the S&P 500 is too tilted to tech stocks (although I have a feeling few are complaining about that exposure right now) or that the FTSE 250 is even more heavily skewed towards resource stocks than its large-cap peer.

Furthermore, picking and choosing which index to invest in based on its components somewhat defeats the purpose of passive investing. But for my money, I’d likely go with a more broad-based index such as the FTSE All Share that covers myriad market sizes and sectors and has a higher exposure to the domestic economy.

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Ian Pierce has no position in any of the shares mentioned. The Motley Fool UK has recommended BP, HSBC Holdings, and Royal Dutch Shell B. 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.