Watch out for the FTSE 100 investment bubble

Jeremy Warner On the investment insanity feeding the rise in the share prices of big companies.
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Anyone who still swears by Schumacher's famous incantation - Small is Beautiful - plainly hasn't been reading his business pages lately. The corporate and investment reality is that big is beautiful. The bigger the better.

Let me explain. Most of us still have some attachment to the idea of small enterprise, with its self help attributes, capacity for innovation and powers of wealth creation. But the truth of the matter is that big is where the action and money lies. Size gives competitive advantage across a wide front, reinforcing the power of the large corporation and making it more and more difficult for smaller competitors to keep pace.

Big companies tend to attract the best and smartest people, they have the lowest operating costs and lowest cost of capital. They have the best IT and management systems, and, if you believe the hype that surrounded Glaxo's attempt to merge with SmithKline Beecham, their greater market clout and R&D expenditure also gives them a better chance of product innovation.

Furthermore, they tend to command a premium in terms of stock market valuation and in recent years their share prices have generally outperformed those of smaller companies. On the face of it, there's no contest; big is simply better.

Just recently, the total stock market value of Britain's top 100 companies soared through the one trillion pound mark for the first time. To be fair, this may not be as significant a milestone as it sounds. Because big companies like to merge one with another and takeover smaller ones, the FTSE 100 share index is bound to suck value into itself. When two Footsie stocks merge, as General Accident and Commercial Union are at the moment, it creates a vacancy which when filled increases the total value of the index accordingly.

Even so, the statistic is not entirely without meaning. Today, the FTSE 100 share index accounts for more than 76 per cent of the stock market's total value. When the index was launched 14 years ago to act as a benchmark for equity futures, the equivalent proportion was only 65 per cent. Put another way, the share of stock market value enjoyed by the next largest 800 companies has fallen from 35 per cent to 24 per cent. On valuation yardsticks too, big companies have significantly outperform their smaller brethren. The FTSE100 index has outperformed the mid cap index (consisting of the next largest 250 companies by market capitalisation) by 30 per cent over the last two years. The yield is lower on the FTSE 100 and the earnings multiple higher.

So what's my point? OK, so I could rail against the power of the corporate state, lament the way in which big business is stifling competition and consumer choice, protest about how big corporations are starving smaller enterprise of capital, or generally get worked up about what a rum old business all this globalisation and consolidation really is. But actually the point I want to make is a comparatively narrow one. I want to examine the proposition that the big is beautiful phenomenon is helping to create a potentially dangerous investment bubble in the FTSE 100 share index.

I know this sounds a little alarmist, a bit over the top. But just listen to this.

Caps, a research organisation which closely monitors investment patterns, this week published its annual survey of pension fund performance. It showed that the collective performance of the big four fund management groups - Mercury, Schroders, PDFM and Gartmore - was 0.7 per cent less than the overall median for fund managers.

For UK equities, this median was itself 1.6 per centage points below the performance of the index, which last year returned 23.6 per cent. For overseas equities, the position was a good deal worse - a performance of only 6.1 per cent against an index return of 19. These figures may look insignificant, but if repeated over time the effect of this comparative under performance on your pension would be sizeable - in some circumstances perhaps as much as 40 per cent of retirement income after 30 years.

It is hardly surprising, then, that pension funds have begun to ask themselves why they are paying all that money for what looks to be pretty poor active fund management. Why not just stick the money in the safe haven of the index, in a basket of the world's leading companies, and watch it grow? There's growing evidence that this is precisely what they are doing. The market share of the big four for new business fell from well over a half in 1993 to 38 per cent last year. Much of this business has gone into index tracker funds.

Moreover, there is plenty of official or semi official support for it. In a recent report on the high cost of personal pensions, John Bridgeman, director general of fair trading, pointed to the underperformance of active fund management and suggested the way forward was in low cost tracker funds. If the same policy stance is taken with the Government's proposed stakeholder pension, there will be an even larger wall of money flowing into the index.

The same follow my leader exercise is repeated within the index. Because banks and pharmaceuticals have sharply outperformed other stocks over the last year, those funds which aren't in these sectors are in trouble. If you are going to lose your job for being underweight in Barclays, you make pretty sure you are not, regardless of any rational assessment of the stock market going forward.

All this is being compounded and exaggerated by the activities of hedge fund operators and the futures market. The hedge funds play off the fear among fund managers of indexation, buying up the stocks where the institutions are underweight and then squeezing the price higher. The need to "delta hedge" futures positions creates its own form of insanity. If stock prices go higher, the futures position must be underpinned with bigger purchases of physical stock, driving the market higher still.

The big investment banks and securities houses are equally culpable. They all have their "global investment priority" hit lists, their "nifty one hundred and fifties", or whatever. Much of this activity takes place in a manner which is divorced from the fundamentals of investment judgment. Fund management is becoming dominated by the belief that big stocks only go up and woe betide you if you miss the elevator.

I'm not going to predict a stock market crash or anything as rash as that. Nonetheless, all previous investment bubbles have been dominated by large stocks too. There is an insanity in what's happening and the dangers of it are all too obvious.