is FTSE 100 diversified enough?

[petronius]

US shares have much more expensive than UK shares, and have therfore significantly lower expected 10 years returns, according to several fonts, including Morningstar Investment Management’s Mike Coop:

https://www.marketwatch.com/story/brace ... 2018-07-05

FTSE 100 is reasonably valued according to CAPE ratio and other metrics (more so than FTSE 250).

Given this situation, does it make sense to have a lot of FTSE 100 in one's share portfolio? This is a practical question for me, as 80% of my shares are currently in FTSE 100 trackers.

My main doubt is whether FTSE 100 offers reasonable diversification in terms of geographical and sector exposure. I am aware that the IT sector is underrepresented and commodities are overweighted in FTSE 100, but would like to hear more detailed views on this and on a portfolio strategy based on holding international index trackers allocated in inverse proportion to their CAPE (or based on some other metrics).

[tjh290633]

I think that you have asked the wrong question. What really matters is whether you can build a portfolio with adequate diversification from the FTSE100.

There is no doubt that the index itself is massively skewed, because of the weight in oils, miners and financials. Replicating the index does not give diversification.

TJH

[Urbandreamer]

Well I remember when one company (Vodaphone) made up 8% of the FTSE100.

I seriously question the concept of using the phrase diversify in conjunction with FTSE100 or indeed any cap weighted index.

Over on the HYP board they are great fans of avoiding cap weighting, although their hunting ground tends to be the FTSE 100 and 250.

If you buy a FTSE 100 tracker, you are betting a significant percentage (10%) of your money on the performance of oil companies. You are also betting 5% on cigs. That's 15% in just three companies! This may or may not produce a good return, but what it is NOT is diversified.

It's the same with a S&P tracker. Some 4% is invested in Apple. That's just one of the 500 companies that make up that index!

Investing in a tracker is easy and may produce good returns, but don't think that you are achieving diversification by doing so.

[Lootman]

I think that you have asked the wrong question. What really matters is whether you can build a portfolio with adequate diversification from the FTSE100.

There is no doubt that the index itself is massively skewed, because of the weight in oils, miners and financials. Replicating the index does not give diversification.

Add pharma,tobacco and utilities in there, but the UK index is sectorally skewed. Income funds potentially even more so.

Or looking at it the other way, there are vital global sectors that the UK has largely abandoned, like manufacturing, autos, chemicals, shipping, agriculture, biotech and IT. You can find small UK companies active in these sectors but the world-leading companies in these sectors are in the US, Germany, Asia etc.

The other factor I would say is political risk. Things like Brexit and a Corbyn government would unduly affect UK companies, even those with foreign earnings, along with other specific single-country political risks like taxation and regulation.

I have much less than 50% of my equity allocation in UK shares and it is still probably too high.

[petronius]

OK, perhaps I should have phrased my question more like:

"Is the weak diversification of the FTSE 100 compensated by its reasonable valuation compared to other markets?"

Or, "How much are you prepared to pay to get exposure to certain sectors that are not adequately represented in the FTSE 100?"

Of course one might argue that the "reasonable valuation" of FTSE 100 is not an anomaly, but rather reflects bad prospects because of Brexit, Jeremy Corbyn, etc.

[Dod101]

I think the importance of diversification is much overdone. However as has been said the FTSE100 is probably relatively cheap for a reason (or maybe two) but it I think boils down to the weakness of the current Government. So I think the main risk is a political one, and I tend to get my protection not so much from direct diversification but more from buying suitable ITs and reducing my exposure to utilities for instance.

Dod

[hiriskpaul]

I have much less than 50% of my equity allocation in UK shares and it is still probably too high.

I hold 10%, split 50/50 FTSE 100/250, plus a little more in some small cap ITs/VCTs. Probably too much as well - the FTSE World Index has only 6%.

[GeoffF100]

As far as the original question is concerned, the FTSE 100 is cheap because of the high risk, principally of Corbyn and/or a hard Brexit. The market does not give a discount for the poor diversification of the FTSE 100, because you can diversify that risk away by investing internationally. A small investor can improve on the sector diversification by departing from market weighting, this involves over weighting smaller less reliable companies. If too much money is invested in these companies, their shares become over priced, and the strategy becomes self defeating.

[OhNoNotimAgain]

The risk of a Corbyn government is zero. Brexit is the least worst option of leaving a Eurozone that is in turmoil. May looks better placed than Merkel, and whoever now leads Italy and Spain. Macron is relying on Merkel to bail out France so although strong politically his options are limited.

The reason why FTSE is cheap is that a lot of long-term money has gone into housing and gilts as a direct consequence of QE and government policy, Help to Buy and Liability Driven Investment are the two main examples of that.

[tjh290633]

As far as the original question is concerned, the FTSE 100 is cheap because of the high risk, principally of Corbyn and/or a hard Brexit. The market does not give a discount for the poor diversification of the FTSE 100, because you can diversify that risk away by investing internationally. A small investor can improve on the sector diversification by departing from market weighting, this involves over weighting smaller less reliable companies. If too much money is invested in these companies, their shares become over priced, and the strategy becomes self defeating.

A small investor has no hope of replicating market weighting, except by using a tracker fund. The only practicable way is to use nominally equal weighting and to be selective in stock selection to avoid over exposure to any one sector. The smaller companies in the main index are not necessarily less reliable than the giants.

As the article says, those who switch from other shares into tracker funds automatically enhance the price of the main constituents and depress those of the smaller constituents. Their weighting goes awry and the risk increases.

TJH

[GeoffF100]

As the article says, those who switch from other shares into tracker funds automatically enhance the price of the main constituents and depress those of the smaller constituents.

That is is not true unless they under weighted the large stocks previously. Small domestic investors tend to favour smaller domestic stocks, but they also favour large overseas stocks. If the large cap stocks become overvalued that is not a problem. Active investors will be keen to sell them (or switch into equally weighted trackers) and that will push the price of the larger stocks down.

If the authors of they article really believe what they are saying, why do they not go long on an equally weighted tracker and short on a market weighted tracker, and make a sure profit?

[GeoffF100]

More to the point, the average holdings of all active investors tracks the market. If a statistically unbiased sample of these investors sell their holdings and buy market weighted trackers, nothing has changed. On average, they still hold the same stocks in the same proportion, the prices should not be affected at all.

[OhNoNotimAgain]

A small investor has no hope of replicating market weighting, except by using a tracker fund. The only practicable way is to use nominally equal weighting and to be selective in stock selection to avoid over exposure to any one sector. The smaller companies in the main index are not necessarily less reliable than the giants.

As the article says, those who switch from other shares into tracker funds automatically enhance the price of the main constituents and depress those of the smaller constituents. Their weighting goes awry and the risk increases.

TJH

The evidence, Fama and French etc, tell us that smaller shares are riskier.

Most active managers, i.e. funds and private investors are overweight small caps because they think they know something about Tiddler PLC that no one else does. That was a winning strategy from 2009 to 2106 when QE favoured riskier shares. Since QE stopped at the start of 2016 the reverse has applied as evidenced by the relative performance of value strategies over those time periods.

[richfool]

A small investor has no hope of replicating market weighting, except by using a tracker fund. The only practicable way is to use nominally equal weighting and to be selective in stock selection to avoid over exposure to any one sector. The smaller companies in the main index are not necessarily less reliable than the giants.

As the article says, those who switch from other shares into tracker funds automatically enhance the price of the main constituents and depress those of the smaller constituents. Their weighting goes awry and the risk increases.

TJH

The evidence, Fama and French etc, tell us that smaller shares are riskier.

Most active managers, i.e. funds and private investors are overweight small caps because they think they know something about Tiddler PLC that no one else does. That was a winning strategy from 2009 to 2106 when QE favoured riskier shares. Since QE stopped at the start of 2016 the reverse has applied as evidenced by the relative performance of value strategies over those time periods.

I tend to see it that smaller domestically focussed companies have suffered because of concerns over Brexit, to the extent that their SP's have been disproportionately depressed, and that once Brexit is resolved, on whatever terms, they will recover, if not soar!

[OhNoNotimAgain]

A small investor has no hope of replicating market weighting, except by using a tracker fund. The only practicable way is to use nominally equal weighting and to be selective in stock selection to avoid over exposure to any one sector. The smaller companies in the main index are not necessarily less reliable than the giants.

As the article says, those who switch from other shares into tracker funds automatically enhance the price of the main constituents and depress those of the smaller constituents. Their weighting goes awry and the risk increases.

TJH

The evidence, Fama and French etc, tell us that smaller shares are riskier.

Most active managers, i.e. funds and private investors are overweight small caps because they think they know something about Tiddler PLC that no one else does. That was a winning strategy from 2009 to 2106 when QE favoured riskier shares. Since QE stopped at the start of 2016 the reverse has applied as evidenced by the relative performance of value strategies over those time periods.

I tend to see it that smaller domestically focussed companies have suffered because of concerns over Brexit, to the extent that their SP's have been disproportionately depressed, and that once Brexit is resolved, on whatever terms, they will recover, if not soar!

The data says otherwise:

FTSE 100 Yield 3.8% PE 13.4
FTSE 250 Yield 2.7% PE 15.2

[hiriskpaul]

To get back to the original question, I would say that 80% in the FTSE 100 is too overweight, regardless of what CAPE values are. I agree with Geoff100, there is no risk based payback for being undiversified and it is so cheap to diversify globally you might as well. Of the major regions, US, Europe, Developed Asia/Pacific, Emerging Markets, it is really only the US that is sitting on a very high CAPE, so you could always underweight the US and overweight other regions if the valuations concern you. For example I recently set up LISAs for my daughters and put 25% in each region as I was partly concerned about US valuations as well. The US would have been 50% by World Index weight. I also invested in a cheap Vanguard global value ETF as a punt that value investing will outperform again over the long term, even though it has not over the last 5-10 years.

One thing to bear in mind is that although CAPE is thought to have some predictive capability, the historic variation in outcomes when starting at particular CAPE values is still very wide. It is not hugely unlikely that the US market will outperform non-US again over the next 10 years, so I would still invest in the US for the sake of diversification, even if it does appear more likely than not that the non-US regions should do better. Another point is that current CAPE values include the earnings from the recession following the banking crisis. If price and earnings stayed the same as now (I know they will not!) CAPE will drop as the lower earnings drop out of the calculation.

[runnygum]

After many years of reading and research I came to the conclusion that VWRL was all I needed.
Its as close to a global balanced portfolio of stocks as I could find.

It costs more than a more narrow index, but thats because it includes everything from everywhere. 90% of the investible market.

[GeoffF100]

It is a cheaper to use VEVE and the appropriate weight of VFEM (about 10%). You can do even better with lots of regional funds, but that gets complicated.

[bluedonkey]

That looks like 0.25% vs 0.18%. Not worth the hassle, I think.

[runnygum]

Correct, especially when you factor in required rebalancing etc. The buy/sell spread and commission on that, as well as time spent will probably cancel out the 7 basis point advantage.