FTSE 100 investing is infested with misconceptions and misunderstandings. Here’s a comprehensive breakdown of the common errors.
As a freelance financial analyst, I spend much of my time covering the FTSE 100 — both the index and its popular constituent companies. FTSE 100 businesses all report their financial activities every quarter, creating masses of analytical opportunities, much of which is fairly irrelevant.
I often think that the UK’s largest companies would benefit from only reporting full year and half year results, so only twice per annum. The constant focus on short-term results may excite investors and traders, but just like politics, I think it is detrimental to a long-term focus on development.
However, this is unlikely to change. What can be adjusted are the misconceptions surrounding the index — which are many and varied. Here, I will address the core issues.
FTSE 100 explained
Let’s start with the basics. The FTSE 100 — a shortened version of ‘Financial Times Stock Exchange 100 Index’ — is a market index composed of the 100 largest companies listed on the London Stock Exchange as measured by their market capitalisation.
Key points to understand include:
- the index is composed of UK blue chip shares across multiple sectors including energy, mining, finance, pharmaceuticals, and telecoms.
- the constituents are reviewed each quarter by FTSE Russell, and can be removed or added dependent on the movement of the largest FTSE 250 shares
- each company’s weighting (or importance to index movement) is determined by its own market cap. For example, one of the largest FTSE 100 companies such as AstraZeneca has a much larger influence than one of the smallest, Persimmon.
- the FTSE 100’s value is therefore calculated using market-cap weighted methodology.
- the FTSE 100 is widely regarded as a benchmark for the UK economy, though in reality it is much more complicated than first appears.
Clearing up the misconceptions
There is a huge amount of misrepresentation of the FTSE 100 in the mass media — some intentional, some not. It’s important for investors to read coverage with the correct background information:
- FTSE 100 movements are often a result of market performance over UK economic performance. Global economic factors, geopolitical instability, and the individual performance of a handful of larger companies at the top can influence the index significantly.
- The FTSE 100 is not a comprehensive picture of London-listed companies; only the top 100 by market cap. Smaller companies on the FTSE 250 or FTSE AIM with larger growth potential are excluded.
- Many of the larger FTSE 100 companies are dual-listed elsewhere; for example, miner Rio Tinto is also on the ASX.
- Real-terms returns are not guaranteed on the FTSE 100, especially with CPI inflation at 8.7%. Many UK investors invest solely in a FTSE 100 tracker and miss out on the better capital appreciation on offer with the US S&P 500.
Understanding the context
When the average retail investor is asked to name a FTSE 100 company, the default response is often ‘Tesco.’ This makes sense as it’s a brand name most of us come into contact with on a regular basis — but the FTSE 100 as an index is dominated by one biotech giant, AstraZeneca, the oil majors, BP, and Shell — the big four banks, HSBC, Barclays, Lloyds, and NatWest — and miners including Rio Tinto and Glencore.
These companies derive almost all of their revenue from overseas. For example, Shell gets only 5% of its revenue from North Sea oil and gas, rendering the windfall tax almost entirely ineffective in the context of its global annual profits.
This is completely at odds with the idea that the index represents the UK economy — instead the FTSE 250 is perhaps a better metric, as it is far more domestically focused.
Indeed, FTSE Russell data indicates that FTSE 100 companies derive circa 82% of their income from outside of the UK. For context, this means that the strength of pound sterling compared to the US dollar is more important than how the UK economy is performing. While the two are intertwined, they are not the same.
To understand this, it’s important to recognise that if a FTSE 100 company generates most of its revenue in US dollars, and then converts this revenue into sterling, a weaker pound means that the index paradoxically does better as the same of amount of US dollar earnings translates into more pounds.
Generally, when the Bank of England increases the base rate, the pound strengthens as it becomes more desirable as an investment. If the base rate rises too far, it hurts some aspects of the UK economy while also hurting FTSE 100 income reporting, so it’s easy to conflate a falling FTSE with a weaker UK economy. But this is simple correlation and not causation.
For context, if interest rates fall, you get a weaker pound, which hurts different aspects of the economy that are reliant on imports.
This nuance tends to get missed by reporters — who are inclined to write sensationalist headlines contending that rate rises and falls are both bad for the FTSE and for the economy at large, rather than picking apart the detail.
It’s also a good idea to look at macro when considering the FTSE 100. AstraZeneca’s success is based on when its patents are going to run out. The oil majors and miners are cyclical shares, reliant on a healthy economy and which struggle in recessionary periods. The banks do well when interest rates rise, but only up to a point, as above a certain level the economy comes to a halt and with it lending.
Passive investing explained
A popular UK investing strategy is to pair a defensive FTSE 100 index-tracking ETF with a similar growth-based S&P 500 tracker. The capital gains of the US index deliver outsized returns in the good times, while the dividends of the FTSE offer some protection during recessionary periods.
You can see this in recent investing history; 2021 saw the US index boom on the back of ultraloose monetary policy, while 2022 saw the FTSE grow by 1% as its stateside counterpart fell into a bear market.
It’s often noted that the S&P 500 has delivered an average annual return of circa 10% since its inception in 1957 — and many investors look at the relatively flat FTSE as a poor man’s version of US shares. However, the FTSE returned an average of 8.3% per year between 2010 and 2019, when you include reinvested dividends.
This falls to 4.3% if you don’t reinvest the dividends, and accounts for the misconception that the FTSE is a much worse choice. Indeed, for those coming close to retirement who can’t tolerate the wilder swings of the benchmark US index, the loss of a couple of percent in returns is often worth the peace of mind of reliable dividend income.
This is a key point, often missed. Most US companies spend their revenue on growth, while most FTSE shares engage in dividends and share buybacks as they are fully established and not seeking to grow further.
FTSE 100: investing vs trading
Of course, this all comes from the perspective of a long-term investor. Traders looking to capitalise on market movements through leveraged trading will always prefer the S&P 500, simply because there is more volatility.
However, this creates a core strength of the FTSE; passive investment from investors reinvesting dividends keeps the index strong. FTSE 100 companies are for long term investors — pension funds like including the companies because the payouts are reliable, and the corporations are regarded as low risk because they are fully matured.
Of course, none of this is investing advice. But when you next read about the FTSE 100, it’s worth understanding more of the full context.
This article has been prepared for information purposes only by Charles Archer. It does not constitute advice, and no party accepts any liability for either accuracy or for investing decisions made using the information provided.
Further, it is not intended for distribution to, or use by, any person in any country or jurisdiction where such distribution or use would be contrary to local law or regulation.
