While the FTSE 100 is the most visible face of the UK stock market, there is far more to the London Stock Exchange than its largest 100 companies. In this article we delve into the UK market and look at how it can benefit your investment portfolio.
SMALLER COMPANIES DOMINATE THE UK MARKET
While the FTSE 100 makes up 81% of the UK market by size, if we look at the number of companies it’s a different story. There are more than 2,000 companies listed on the London Stock Exchange and just 5% of these are in the FTSE 100. The mid-cap companies of the FTSE 250 make up another 12% but it is small-cap companies that dominate. Even after a fall in the number of listed companies over the last decade these still make up 83% of the market by number. Increasingly few of these are on the Main Market - smaller companies now typically head to the less strictly regulated Alternative Investment Market (AiM), which has more than 1,000 companies. Some of these are not so small – the largest AiM company, online fashion retailer ASOS, is worth almost £4 billion, making it larger than some FTSE 100 companies.
THE IMPACT OF SIZE IN THE FTSE 100
The size of the FTSE 100 is largely explained by the companies at the top end. All told the top five make up 29% of the index and the top ten 44%. In fact, HSBC, Vodafone and BP are each worth more than the entire AiM market, which comprises more than 1,000 companies. This presents risks, even to investors in a supposedly diversified FTSE 100 tracker fund. The 2010 Deepwater Horizon oil spill halved the value of BP, then 7% of the index, whilst Alliance & Leicester, Bradford & Bingley and Northern Rock disappeared entirely during the banking crisis. Even today HSBC makes up almost 8% of the FTSE 100. In contrast the largest company in the FTSE 250 is 1.3% of that index and just 0.2% of the market as a whole.
The FTSE 100 is also concentrated by sector. A wave of new listings over the last decade means Oil & Gas and Mining companies make up around 25% of the index, compared to 15% for stock markets globally. The FTSE 100 also has a high weighting to financials – even after the troubles at Lloyds and Royal Bank of Scotland, banks make up 14% of the index whereas in the FTSE 250 there is just one bank, Bank of Georgia.
While meganames such as Tesco and Sainsburys reside in the FTSE 100, consumer-focused companies are common in the FTSE 250, which contains an array of high street retailers such as Ladbrokes, WH Smith and Carpetright. There are also quite a number of mid cap housebuilders with the likes of Barratt Developments and Taylor Wimpey having benefited from the recent bounceback in the UK housing market.
One common factor regardless of company size is the low exposure to technology, which makes up just 1.5% of the UK market. This compares to almost 10% for stock markets globally so it looks like it will be a while before the UK produces its own Apple or Google.
The FTSE 100 has long been dominated by multinationals and around 70% of its companies’ sales are overseas. The increase in the number of commodity companies has made it more international still and some of these companies have minimal exposure to the UK. This geographic diversification is a double-edged sword: it provides diversification away from the UK economy but at the same time increases correlation to overseas companies that might already be in investors’ portfolios. A good example is Shell and Exxon. They might be based on different continents but their underlying businesses are fairly similar. In contrast, 50% of FTSE 250 and AiM sales are overseas, and just 40% of the FTSE Small Cap. Small and medium-sized companies also provide the bulk of the country’s jobs.
Historically smaller companies have been more volatile than larger companies, and this is still the case. However, the risk gap has narrowed. The higher weighting to typically risky resource companies has upped the volatility level of the FTSE 100, though this is somewhat mitigated by the inclusion of companies in more stable areas such as tobacco. Whilst small caps generally are still more volatile, the sheer number of stock opportunities further down the size scale means it’s possible to avoid the riskier companies. John McClure’s small-cap focused Unicorn UK Income, has actually been less volatile than the market as a whole.
… AND RETURN
Perhaps the most crucial difference is in growth rates. Over the last 10 years, the FTSE 100 has risen 121% and the FTSE Small Cap 120%. However, the clear standout has been the FTSE 250, which has risen 245% over the period. Partly this reflects specific problems with large companies such as the banks. However, research suggests that, over the long term, smaller companies outperform larger ones.
As global companies, FTSE 100 shares are high profile and heavily researched. This makes it harder for active managers to find the information edge that leads to outperformance; successful large-company specialists such as Richard Buxton (Old Mutual UK Alpha) are few and far between. The small and mid-cap indices contain far more hidden gems that a savvy fund manager can seek out and benefit from. The FTSE 250’s stellar performance hasn’t stopped Chris St John from doing even better on AXA Framlington UK Mid Cap.
The UK market is highly diverse. The FTSE 100 contains world-beating companies that belong in almost any equity portfolio but by restricting yourself to large companies you’re seriously limiting your options. We typically say that clients should overweight both medium sized and smaller companies. Though they can be riskier than larger companies, they typically offer faster growth and more opportunities for fund managers to outperform. And with recent data suggesting the UK economy is finally beginning to recover, more domestically focused companies might just be the place to be.