The FTSE 100 index, the leading benchmark for UK shares, has again broken through the 5,000 level this week.
The FTSE 100 index, the leading benchmark for UK shares, has again broken through the 5,000 level this week. However, investors who opt for a strategy of tracking the Footsie may not be aware of the nature of the risks they run - and about the opportunities they miss by sticking to an index of Britain's 100 biggest companies by market valuation.
Their money is not distributed evenly across these companies, which range from the oil giant BP at the top of the spectrum to the copper producer Antofagasta. In fact, cash is allocated by company value.
So, for every £100 invested, nearly £10 is used to buy shares in BP, while just 8p is used to purchase stock in Antofagasta.
And as the big companies become ever bigger, often through merger and acquisition, even more of a FTSE 100-index-investor's money is skewed to a handful of companies such as BP. The largest five firms - BP, HSBC, Vodafone, GlaxoSmithKline and Royal Bank of Scotland - account for 36 per cent of an investor's cash. Just 10 companies make up half of the index.
A lack of stock-diversification is not the only risk for investors who opt to shadow the FTSE 100 index. This approach also leaves investors exposed to a relatively small cluster of sectors. The 10 companies that make up half the benchmark cover just four industries: oil (BP, Shell); telecoms (Vodafone), pharmaceuticals (GlaxoSmithKline, AstraZeneca); and banks (HSBC, Royal Bank of Scotland, Barclays, HBOS, Lloyds TSB).
So, should just one of these sectors disappoint, the impact on performance can be disproportionate.
And the dangers posed by sector concentration are set to become more acute. At present Shell, the Anglo-Dutch oil group, has a stock-market quotation in both London and Amsterdam. But Shell has plans to consolidate its capital base, with shares listed solely in London. This will double Shell's portion of the FTSE 100 index from its already hefty level of 3.9 per cent.
In that event, oils will vie with banks for the dominant position in the Footsie. If Shell's weight doubles, then oil stocks will account for nearly 18 per cent of the index. Banks currently make up more than 20 per cent of the benchmark (there are eight). In other words, for every £100 invested in a fund that tracks the Footsie, nearly £40 goes straight into banks and oils.
Stock and sector concentration is of such concern to pension-fund and other institutional investors that FTSE International has recently produced a series of indexes that impose a five-per-cent "cap" on individual shares. So, though BP accounts for 10 per cent of the market, no more than five per cent of investors' money will go on it.
There is a third risk to shadowing the top 100 companies. While many of Britain's blue chips look more attractive than they have done for some time, it seems odd to limit your investments in this way when there are about 700 companies with a full listing on the London Stock Exchange. You can miss out on profitable opportunities.
Shares in the FTSE Mid 250 index - the group of companies that have yet to reach sufficient size to enter the premier league but which includes many well-known names - have in recent years out-performed the blue chips. Investors who backed the Footsie two years ago have seen the value of their portfolios rise 20 per cent (before charges). Those who put their money into the mid-caps have earned 42 per cent.
Big may indeed be beautiful, but it would be a peculiar strategy to limit your investments to the market's behemoths, particularly given the issues of sector and stock concentration.
Sanjeev Shah manages the Fidelity UK Aggressive fund.Reuse content