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Index trackers take a bigger gamble

Fund managers who hug the UK indices will have had to further increase exposure to the oil and gas sector.

Benchmark-driven approaches force fund managers to decide between investing in stocks they may not actually like or risk underperforming the index because they are not invested in one of the big companies.

Last week, one of the biggest FTSE companies became even bigger. The unification of Royal Dutch Shell meant that, instead of having part of the company listed and quoted in the Netherlands and part in London, the whole company is now listed in London. As a result, just two oil companies – Shell and BP – make up 16.5 per cent of the All Share index, which consists of over 700 companies.

Since Shell’s unification, the top 10 shares in the All Share account for 45.9 per cent of the index. For comparison, in the All Share of 1990, the 10 biggest shares accounted for 27 per cent of the index. This is an increase in the market capitalisation of the 10 biggest companies of 18.9 per cent over 15 years.

Concentration in the All Share is not limited to the oil and gas sector. Four humongous sectors now dominate the index. The others are banks (17.8 per cent), telecoms (8 per cent) and pharmaceuticals (7.95 per cent).

The point of all this is that benchmark-hugging managers are being forced to put more money into certain companies and sectors, not on any fundamental change in the outlook but because of technical changes in the index. As managers continue to invest in oil and banking shares, investors are exposed increasingly to three economic levers – the oil price, the dollar and interest rates. These variables are beyond the control of management teams, no matter what their skill level.

Shell is not the only company that benchmark-driven managers have been forced to pile money into in recent weeks. Funds were forced to buy the Gibraltar-domiciled online gambling stock Partygaming as it floated with a value of 5bn and instantly entered the FTSE 100. I believe the resulting portfolios are becoming much more risky. Investors in index trackers will find their savings underdiversified and overexposed to a few volatile sectors and macro factors beyond the control of the manager.

For most of my career, I have been managing ethical investments which are constrained from investing in most of the biggest FTSE com- panies or sectors for ethical reasons. For example, banks are off limits because they profit on bad debts, oil companies operate in areas with human rights violations, pharmaceutical companies perform animal testing and tobacco and alcohol companies are out of bounds. As a result, I have never been able to hug an index.

I use a much smaller investment universe than most managers, so I also perform lots of fundamental analysis in order to choose stocks in an intelligent way rather than following the herd mentality.

Although I now also manage an unconstrained fund – F&C UK growth and income – I am not remotely tempted to start mimicking a benchmark. I believe that fund managers should invest in the shares they think will perform well and avoid those that are regarded as losers.

This is not a radical outlook but it is vastly different from managers who invest in companies they hate just because they are in the index. I will happily buy these big stocks when they look attractive to buy and the fundamentals look favourable. For now, I am concentrating on those opportunities overlooked by benchmark-driven managers.


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Neptune video: Indian valuations and Modi’s pro-investment agenda

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