FTSE 100 Diversification – Buying big

The FTSE 100 is weighted by market capitalization. Because of this, the largest companies have a significant impact on the overall performance of the FTSE 100.

In fact, the 10 largest companies in the FTSE 100 make up 43.4% of the index. Therefore, you may think that owning these companies is a safe way to diversify in line with the FTSE 100. However, history shows that this is not the case.

 

What is the FTSE 100?

As described in our analysis of FTSE vs government bonds, the FTSE 100 Index, also called FTSE 100, is a share index of the 100 companies listed on the London Stock Exchange with the highest market capitalization. It is one of the most widely used stock indices. It is seen as a gauge of business prosperity for business regulated by UK company law. The index is maintained by the FTSE Group, a subsidiary of the London Stock Exchange Group.

 

FTSE 100 and FTSE 250 ten year performance

Since 2003, the annualized net return of the FTSE 100 Is 6.0% per annum (3.5% return with 2.5% dividend yield). In comparison, the FTSE 250 returns 11.1% (9.1% return with 2.0% dividend yield).

Given the 43% coverage of the largest 10 companies, we would assume that their performance would reasonably match the overall FTSE 100 performance. We would assume incorrectly.

 

Top 10 constituents

In May 2003, the ten largest FTSE 100 companies were:

BP
HSBC Holdings
Vodafone Group
GlaxoSmithKline
Royal Bank of Scotland Group
Shell Transport and Trading Co
Barclays
AstraZeneca
HBOS
Lloyds TSB Group

Top 10 performance

The performance of the ten largest companies has varied wildly over this period. Not the “large, steady companies” that many people think of for the FTSE’s largest constituents.

Looking at the largest ten companies in May 2003, the best performer is Vodafone group, returning 8.8% per annum (including dividends). However, the weakest performer, RBS, has fallen by almost 25% each year.

Therefore, the FTSE To p 10 has increased by 0.7% each year, meaning that an original investment would now be worth £10,592.97.

If invested in the FTSE 100 index, this would have increased by 6.0% per annum, with the investment increasing to £13,357.71.

If invested in the FTSE 250 index, this would have increased by 11.1% per annum, with the investment increasing to £21,005.07.

 

Impact of poor performers

In this analysis, we have included the top 10 companies. However, the FTSE 100 and FTSE 250 effectively remove the performance of terrible performers as these often fall out of the index. Therefore, we can reanalyze the Top 10 performance with a stop loss.

In this scenario, we sell once a share price falls by 30%. We then invest the remaining funds at 2% interest for the remainder of the period.

Therefore, while this stop loss does improve our performance, it does not even return half of the returns offered by the FTSE 100 as a whole (and this ignores the trading costs for selling these shares).

 

Does big mean safe?

You may assume that buying the FTSE’s largest shares is a safe way to invest. However, this is not the case. Big companies can, and almost always do, fail.

Today, only 26 companies for the FTSE’s original line-up remain. This is due to many factors including takeovers and mergers. However, for the largest companies, the move from inside the top 10 to outside is usually down to failure, which is a cost borne by the shareholder.

Therefore, sticking to a FTSE 100, FTSE 250 or FTSE All-share tracker tends to be less volatile and produce better results than trying to “diversify” through large individual stocks in the market.