Why the FTSE isn’t a great benchmark for a diversified portfolio
By Nic Spicer - February 10, 2022
UK retail clients often use the FTSE 100 or FTSE All Share as a benchmark for measuring how their portfolios are performing. As these are the most widely quoted indices in the UK news this is understandable, but they aren’t good benchmarks for any client who owns a diversified portfolio.
Over the long-term, diversification is helpful in improving risk-adjusted returns for clients but, as we witnessed in January with the FTSE, in short-term periods, it can lead to underperformance vs any single country benchmark.
To understand what’s going on, it’s worth looking at the issue in more detail.
What is the FTSE All Share and FTSE 100?
The FTSE All Share is a market capitalisation weighted index of almost all companies listed on the London Stock Exchange. Currently this is 600 companies covering 98% of the UK’s market capitalisation (the other 2% failing index compiler’s FTSE Russell’s size and liquidity criteria for the index).
The FTSE 100 is a subset of the FTSE All Share consisting of its 100 largest company constituents. The FTSE 100 makes up over 80% of the FTSE All Share, so these two indices perform very similarly. For this reason and for simplicity, I refer to them interchangeably below as the ‘FTSE’.
Why has the FTSE performed so well recently?
January saw a general selloff in bonds and a major rotation away from more expensive ‘growth’ equities towards cheaper ‘value’ equities. As well as affecting performance within regions, this has also had a remarkable effect between indices.
The UK market contains lots of value equities: financial services (banks and insurers), energy (oil & gas), materials (miners) and consumer staples (food, household goods, alcohol and tobacco). The UK market also has very little exposure to ‘growth’ sectors like IT and communication services (which in the US includes the likes of Google and Facebook).
The FTSE is thus perceived to be, and very much behaves like, a ‘value’ index. As cheap banks & insurers, miners and oil & gas companies outperformed in January, so too did the FTSE.
Because the performance of individual asset classes is so uncertain, we at PortfolioMetrix build our portfolios out of many different asset classes.
Rather than just investing in the equities of the 100 (or even 600) largest companies in the UK, we invest in companies outside the UK too. Moreover, we don’t just invest in equities. We invest in other asset classes like cash-like instruments, bonds of all types, property and infrastructure.
The performance of some asset classes is less uncertain than others. Cash returns are the most reliable, followed by bonds with a short time until they mature. The performance of bonds with a longer time to maturity is more uncertain, but still far more reliable than equities which have highly variable returns.
Blending a multitude of assets together allows us to construct diversified portfolios that have different risk levels but above all, they are never reliant on just a single asset class.
The advantage of this approach is greater certainty of return and a ‘smoother’ investment journey. In a portfolio, you get the ‘average’ return of all your holdings and so avoid the chance of getting the performance of assets that implode.
Of course, this means that diversified portfolios will inevitably underperform at least one of their holdings, and with hindsight you are likely to wish you had held more of that particular asset. Hindsight is 20/20 but it’s important to remember that future returns are much harder to predict, which is why diversification is so important.
In January, the outperforming asset was the FTSE. It’s worth noting though that longer-term, the FTSE has lagged other developed markets. Brexit does seem to have been a factor here but banks, a key holding in the FTSE, never properly recovered post the financial crisis and commodity stocks, another big part of the index, have also generally stagnated until very recently.
2020 and COVID lockdowns were particularly painful for the FTSE, so some of the recent outperformance is just a partial recovery of those losses.
The key question is whether the FTSE will continue to perform as strongly as it finished 2021 and started 2022.
The UK’s stock market is, after years of underperformance, very cheap. Being cheap is not the same as undervalued, but we’d argue that the UK market is actually both at the moment.
Market fluctuations are something our investment team is used to responding to and we have adapted our portfolios to take advantage of the opportunities offered by the FTSE by having a decent exposure to UK stocks.
However, we remain solidly committed to diversifying our portfolios across multiple asset classes, regions, currencies and companies. As past experience has shown, the FTSE is, like every single equity region, a risky asset class equally capable of underperforming, which is why a strategy of diversification makes sense for anyone mindful of the risks associated with investing over the long-term.