FTSE 100 tracker funds have become very popular investments in recent years. When the index was rising, investors viewed them as an easy, cost-effective way to profit.
But now we’re in a bear market and stocks are falling. That means some of the flaws of passively-managed tracker funds are being exposed. Here, I’ll look at some of the drawbacks of owning FTSE 100 tracker funds. I’ll also explain why I believe investors are better off picking individual stocks in the current environment.
No control over your holdings
The main disadvantage of tracker funds is you have no control over your holdings. You simply own the whole index. In the current environment, where there’s an enormous amount of economic uncertainty, this could be a potential setback.
For a start, if you own every stock in the FTSE 100, you’re going to have exposure to a number of companies that could be impacted significantly by Covid-19. I’m talking about companies such as International Consolidated Airlines, easyJet, Carnival, and Compass Group. These could take a while to recover from the disruption, meaning their share prices could be depressed for a while.
Additionally, if you own the whole index, you’ll also have exposure to a number of companies that could be vulnerable in an economic downturn. BT Group and Centrica are among those that come to mind here. Both have alarming amounts of debt on their books, which adds risk. I wouldn’t want to own these in a recession.
Ultimately, if you buy a FTSE 100 tracker fund, you’re at the mercy of the market. To quote Martin Gilbert, chairman of Aberdeen Standard Investments: “Passive strategies leave investors fully exposed to the teeth of the bear.”
A more selective approach could pay off
In my view, it could pay to be more selective about your investments. That means buying individual stocks. This approach has several advantages.
Firstly, you can focus on high-quality companies likely to be less vulnerable in a recession. Unilever and Reckitt Benckiser are good examples (both have recently outperformed the FTSE 100 significantly) as they’re seen as consistent performers.
Secondly, you can focus on companies likely to be impacted less by the coronavirus. Accounting solutions provider Sage is a good example. It should be relatively well insulated from the disruption.
Finally, you can focus on stocks that look oversold and have the potential to rebound significantly. Names that come to mind include Legal & General Group and JD Sports Fashion.
This is certainly the approach I’m taking right now. Instead of just buying the whole index, I’m focusing on high-quality companies I think have the potential to outperform the market.
I believe that in the current environment, this approach should provide higher returns than a FTSE 100 tracker.
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Edward Sheldon owns shares in Unilever, Reckitt Benckiser, Sage, Legal & General and JD Sports Fashion. The Motley Fool UK owns shares of and has recommended Unilever. The Motley Fool UK has recommended Carnival, Compass Group, and Sage Group. 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.