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The FTSE 100 might look cheap but here’s why I’m buying the FTSE 250

Over the past three months, the performance of the UK’s leading stock index, the FTSE 100 has been mixed. After jumping to an all-time high of 7,779 at the beginning of 2018, by the end of March, the index had collapsed by nearly 1,000 points to 6,889 taking it back to a level not seen since the end of 2016. 

Since hitting this low, the blue-chip stock index has since recovered, but the big question has to be, is it time to buy ahead of further gains?

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Time to buy the Footsie? 

The answer to this question isn’t easy. Trying to predict the direction of a global stock index like the FTSE 100 is a complex, and some might say an impossible, process. As more than two-thirds of the index’s profits come from outside the UK, the fortunes of its constituents depend more on the global economic environment than on the economic situation at home.

Still, there’s no denying that the UK market as a whole looks cheap compared to the rest of the world. The UK market is trading at an average P/E of 14, compared to 20 for the United States’ S&P 500. Using this metric alone, it’s not unreasonable to suggest that the market could rise as much as 43% from current levels to trade at the same valuation as the S&P 500.

The FTSE 100 also looks cheap on an income basis. The index currently supports a dividend of just under 4% compared to current interest rates (10-year Gilts) of 1.4%.

However, despite the attractiveness of the FTSE 100, I prefer the FTSE 250 as a long-term investment.

UK-focused investment 

The FTSE 250 is much more focused on the long-term success of the UK. What’s more, while a large percentage of the FTSE 100 constituents are resource companies, the FTSE 250 is more diversified, meaning the index is less sensitive to global macroeconomic trends.

The benefits of this diversification show through clearly in the difference in returns of the two indices over the past 20 years. As the FTSE 100 has peaked and fallen again with the dotcom crisis, financial crisis, and most recently, the commodity price crash, it has produced a total capital return for investors of only 24% (excluding dividends).

Meanwhile, the FTSE 250, with its collection of trailblazing UK-focused mid-caps has returned nearly 270% (excluding dividends).

Having said all of the above, if you are worried about the impact that Brexit might have on your portfolio, then perhaps the FTSE 100 might be a better buy, thanks to its global diversification. But I believe that a better method of diversifying away from the UK is to buy another international index with a record of strong returns, such as the S&P 500.

Overall, I believe the FTSE 250 is a much better buy than its blue-chip peer thanks to its focus on smaller UK companies. You can buy tracker funds for both indexes for less than 0.2% per year in fees. So not only is this an easy, effective and profitable way to invest, it’s cheap as well.

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Rupert Hargreaves owns no share mentioned. The Motley Fool UK has no position in any of the shares mentioned. 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.

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