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

Why the FTSE (INDEXFTSE: UKX) may not be all its cracked up to be for retail investors.

The content of this article was relevant at the time of publishing. Circumstances change continuously and caution should therefore be exercised when relying upon any content contained within this article.

When investing, your capital is at risk. The value of your investments can go down as well as up and you may get back less than you put in.

Read More

The content of this article is provided for information purposes only and is not intended to be, nor does it constitute, any form of personal advice. Investments in a currency other than sterling are exposed to currency exchange risk. Currency exchange rates are constantly changing, which may affect the value of the investment in sterling terms. You could lose money in sterling even if the stock price rises in the currency of origin. Stocks listed on overseas exchanges may be subject to additional dealing and exchange rate charges, and may have other tax implications, and may not provide the same, or any, regulatory protection as in the UK.

You’re reading a free article with opinions that may differ from The Motley Fool’s Premium Investing Services. Become a Motley Fool member today to get instant access to our top analyst recommendations, in-depth research, investing resources, and more. Learn More.

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.

Passive income stocks: our picks

Do you like the idea of dividend income?

The prospect of investing in a company just once, then sitting back and watching as it potentially pays a dividend out over and over?

If you’re excited by the thought of regular passive income payments, as well as the potential for significant growth on your initial investment…

Then we think you’ll want to see this report inside Motley Fool Share Advisor — ‘5 Essential Stocks For Passive Income Seekers’.

What’s more, today we’re giving away one of these stock picks, absolutely free!

Get your free passive income stock pick

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.

Pound coins for sale — 31 pence?

This seems ridiculous, but we almost never see shares looking this cheap. Yet this Share Advisor pick has a price/book ratio of 0.31. In plain English, this means that investors effectively get in on a business that holds £1 of assets for every 31p they invest!

Of course, this is the stock market where money is always at risk — these valuations can change and there are no guarantees. But some risks are a LOT more interesting than others, and at The Motley Fool we believe this company is amongst them.

What’s more, it currently boasts a stellar dividend yield of around 10%, and right now it’s possible for investors to jump aboard at near-historic lows. Want to get the name for yourself?

See the full investment case

Should you invest, the value of your investment may rise or fall and your capital is at risk. Before investing, your individual circumstances should be assessed. Consider taking independent financial advice.

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.

More on Investing Articles

British Isles on nautical map
Investing Articles

This industrial giant is the UK’s largest business, but it’s not a FTSE 100 stock!

The FTSE 100 index is an obvious place to look for Britain's biggest companies, but the most valuable UK stock…

Read more »

Young Asian man drinking coffee at home and looking at his phone
Investing Articles

Here’s a 5-stock FTSE 100 portfolio that could generate £800 a month in passive income

Mark Hartley calculates the potentially lucrative returns of five popular FTSE 100 dividend stocks invested in a Stocks and Shares…

Read more »

Investing Articles

Up 40% in 2025, is this 1 of the best cheap UK shares to consider buying right now?

Looking for UK shares to cash in on the gold rush could be a great idea to consider. Here's one…

Read more »

Portrait of elderly man wearing white denim shirt and glasses looking up with hand on chin. Thoughtful senior entrepreneur, studio shot against grey background.
Dividend Shares

Is it wrong for me to buy these FTSE 100 tobacco stocks?

These two FTSE 100 tobacco stocks have thrashed the wider UK market over one and five years. But would it…

Read more »

Investing Articles

Is this a great opportunity to lock in big dividend yields for a second income?

Dividend yields rise as share prices fall. That’s why many investors will see a bear market or correction as an…

Read more »

Investing Articles

How much could a 30-year-old ISA investor have if they invested £500 a month until 60?

Generous tax advantages mean Stocks and Shares ISA investors can boost their chances of enjoying an early retirement.

Read more »

Young female business analyst looking at a graph chart while working from home
Investing Articles

After collapsing 28% today, are Bunzl shares too cheap to ignore?

A poor trading statement has sent Bunzl shares to multi-year lows. Could now be a good time to consider investing…

Read more »

Investing Articles

These 5 stocks could earn £1,600 of annual passive income in a £20,000 ISA

Harvey Jones shows how to generate a high and rising passive income by buying a balanced mix of high-yielding FTSE…

Read more »