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Caps in hand

In this article I will conclude my discussions about the use of different asset classes and sectors by highlighting a few of the key variables and factors in the selection of equity funds within a portfolio. Some of these issues are mostly or entirely subjective but, as I started to outline in my last article, others can be scrutinised in a mathematical or objective way.

First, a few words about income yields. If a fund is invested broadly in FTSE 100 companies, the current dividend yield on that index indicates an overall annual income of a little over 3 per cent. This yield is “covered” around 2.5 times, meaning that so long as corporate profitability is at least maintained and so long as there is no major trend towards paying lower dividends, this level of income should be safe.

As I noted in my last article, informative, interesting and useful summary data in each Saturday’s Financial Times and other sources confirms continuing healthy increases in both profitability and the level of dividend payments. With a price/earnings ratio of 12.65 in this sector, the potential for income yields and further increases to share prices surely looks healthy, even though this index has risen by 20 per cent over the last 12 months.

Some funds concentrate share selection on companies outside the biggest 100. Mid-caps or companies outside the FTSE 100 but not among the smallest on the stockmarket, are represented by the FTSE 250 index. The dividend yield on this index is much lower than the FTSE 100 at 2.3 per cent with lower dividend cover of 2.4 times.

These comparisons, as also represented by a p/e ratio of 18, might appear to indicate, on mathematical grounds, unfavourable investment conditions for mid-caps against the FTSE 100. In reality, the main subjective message is that the market clearly thinks that companies in this sector have greater growth prospects overall.

This principle continues with the smallest companies in the stockmarket, as represented by the FTSE small-cap index, which indicates an overall dividend yield of 2.1 with cover of 1.35. The p/e ratio is over 34, indicating the higher growth prospects – though without certainty, of course – of these smaller companies, which is quite understandable as these are often young companies or those hoping to recover from bad times.

It needs to be noted that, in all these sectors, individual companies will vary from the index summary.

It is interesting to note, even more importantly than the outperformance of mid-caps over the last 12 months, the almost total dominance of the size of the biggest100 companies on the stockmarket. This being the case, unless collective equity funds specify a predominance of stock selection, the FTSE 100 will arguably be the most appropriate benchmark.

This leads me on to another issue relating to collective funds in particular, as well as equity portfolios generally, and that is the number of different shareholdings and their distribution between sizes of company. Start by considering a mythical portfolio invested entirely in the shares of just one company. The performance of this portfolio will depend entirely on the performance of that one share.

If that share outperforms the average, so will the portfolio, and the reverse is also the case. Of course, simple mathematics dictates that this portfolio is highly unlikely to perform in line with the average of its more widely diversified peers as, by definition, a single share is almost certain to outperform or under-perform the average of an index of which it is a part.

More realistically, consider a portfolio of two shares. The volatility of this portfolio will be lower than the volatility of a single share. This principle can then be developed to portfolios of three, five, 10, 20 or 100 shares. Fundamentally, the bigger the number of shareholdings, the lower the volatility against their appropriate index.

And the point? If a UK equity fund invests mostly or entirely in all 100 shares in the FTSE 100 in proportion to their share prices’ contribution to the index, the fund will become a tracker fund. But often with higher “management” charges. How skilful does the manager of this fund have to be? If, say, Vodafone’s share capital represent 3 per cent of the total share capital of the FTSE 100, then the temptation for the manager might be to invest 3 per cent of the fund in Vodafone shares. The higher the number of shares in the fund, the closer will be the fund’s performance to its appropriate index. These funds should perform close to the sector average and will therefore consistently and reliably feature in the second and third quartiles of their sector’s tables. Funds with many fewer holdings, say, 20 for example, require more attention from the fund manager and are more likely to stray from the sector average in terms of performance.

So, expect funds with a small number of holdings to often feature in the first or last quartiles and to experience a much higher level of volatility than more broadly-based funds with a larger number of holdings.

I am not suggesting that any of these rules should be taken as infallible but the mathematical principles on which they are based can and should continue to give potentially valuable guidance to pension and investment advisers and their clients.

Looking at a practical example of the use of this observation on focused funds and broad-based funds, the principle of pound/cost averaging works best – if it works at all with volatile funds. Here, as the unit price of funds falls, probably faster than their appropriate index, more units are purchased by a periodic investment. As the unit price rises, these units might be expected to rise in value faster than that index. Fine, perhaps, for regular contributions to a pension or any other investment vehicle but risk-adverse clients making ad hoc lump-sum investments might prefer lower-risk, broader-based funds if, indeed, equities are appropriate for their needs in the first place.

Finally, an update on the future prospects for the main asset classes on which I have been commenting over the last few articles, especially in the light of very recent developments in world equity markets.

The FTSE 100, having broken through a resistance level of 6,000 has at the time of writing remained above that level and started to surge forwards. Chartism suggests that the 6,000 mark has now become a support level, below which the index should not fall in the foreseeable future. This mainly mathematical theory also now suggests further rises. The Dow Jones continues to test its own resistance level of 13,000 but might then be expected, by Chartism theory at least, to rise sharply.

European markets have tested and broken through their respective resistance levels and so non-UK equity funds also appear positive. This takes me to my final point of discussion in this article – the high correlation between European and US stockmarkets. In short, when the Dow goes up, so does the FTSE and so does Germany, France, Italy and so on. The same on the way down.

This being indisputable means that diversification within an equity portfolio between funds invested in a range of UK, European and US shares produces relatively little reduction in risk. True, the diversification might look good to the investor and feel good for the adviser but let everyone be aware that the reduction in overall volatility is likely to be small.

But one very subjective observation finishes this article. The other major European markets indicate a p/e ratio of between 14.5 and 20. The FTSE p/e ratio is 12.65. Many independent reports suggest that our economy is in a healthier state than theirs. If true, either we are too cheap or they are too dear. My bet is on the former so I think we will outperform them on the way upwards. With cash and fixed interest continuing to look disinteresting and property looking a little vulnerable, investors’ money will be directed increasingly to equities. Supply and demand, and all that, perhaps?comparison of indices

Index Dividend Cover Price 12-month

yield index change

FTSE 100 3.1% 2.5 12.65 +20%

FTSE 250 2.3% 2.4 18 +40%

Small caps 2.1% 1.35 34.55 +21%

All Share 3.0% 2.5 13.4 +22%

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