index investors need to beware huge sector bias of ftse 100

RWC Partners’ Ian Lance and Nick Purves look at the make-up of the FTSE 100 index and urge investors to be wary of passive investing in an index with 35% in just two sectors.

index investors need to beware huge sector bias of ftse 100

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As with the tech IPOs, many of Glencore’s traders became overnight multi-millionaires and, in some cases, billionaires on the float. Vallares is a cash shell run by former BP chief executive Tony Hayward with no operating history, no revenues and no basis on which to evaluate the company. They do, however, have a plan to go out and do deals in the energy sector.

Signs of a bubble
 

Both of these, supported by major investment banks, were heavily over-subscribed such is today’s popularity for anything related to commodities. The real impact of this, and the parallel with the TMT bubble, is shown in the make-up of the UK index and the implications that this has for passive investors.
 

In March 2000, the FTSE index committee took nine companies out of the FTSE 100 and replaced them with companies that fundamentally altered the composition of the index. The companies going in were in the hot areas of the day such as telecoms and technology. Many were young and with questionable business models, all had seen their share prices go up a lot in the previous year and looked very expensive.
 

The deletions tended to be old economy stocks which had been out of favour and subsequently were very cheap. Secondly, the subsequent performance of the deleted companies was much better than that of the new entries.
Buyers of passive funds should take note of this; when you go from active to passive you reduce tracking error but not necessarily the risk of owning expensive businesses.
 

Today, again, there has been a complete change in the composition of the FTSE 100 which now has a 15% weight in the mining sector (including names such as Eurasian Natural Resources, Kazakmys and Vedanta) and 20% in oil companies. Passive investors therefore need to appreciate that returns of the UK index will be heavily influenced by the future direction of oil and other commodity prices.

Governance issues
 

Another issue is around the standard of corporate governance at many of these companies, which also has the potential to influence future shareholder returns.
 

Sadly, there are direct comparisons to the late 1990s when enthusiasm for technology companies meant that shareholders, investment banks, exchanges and regulators alike turned a blind eye to corporate governance. The unsavoury consequences of this were meant to have been dealt with by acts such as Sarbanes Oxley which aimed to reduce conflicts of interest and improve standards of corporate governance.
 

Ten years on, many of us still wonder why the analysts at banks involved in IPOs seem to have a strong tendency towards positive research on new issues. When ENRC sought to list in London, they did not have the required 25% minimum free float but the listing authority decided to relax this requirement.
 

Those who are de-risking their portfolios by switching from active to passive need to be very aware of the risks they are removing (primarily tracking error) and the risks that they are taking on (buying expensive as well as cheap stocks, and buying some potentially very poor quality businesses). In the UK, this issue is even more acute as over a third of the index is in the energy and materials sectors.
 

Hence, the buyer of UK index funds is taking a large bet on the future performance of commodity prices. Unfortunately it appears that enthusiasm for the commodities super cycle risks repeating many of the mistakes of the TMT bust.

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