Once an investor has made the thorny decision over whether they want to look for an active fund manager, or simply to track an index, it may feel like all the hard work is done. In fact, passive funds come in a range of different guises. Perhaps the most important way in which they differ is in the choice of index they replicate.

In the UK, there are two major indices that investors can choose to track: The FTSE 100, which covers the UK’s largest 100 companies by market capitalisation; and the FTSE All-Share, which captures a wider universe – around 98% of the London Stock Exchange, currently 642 companies.

The choice of index may seem like a niche point: After all, the FTSE 100 and the FTSE All Share both provide broad-based exposure to companies listed in the UK. The key difference is that the FTSE All Share includes mid and small cap areas, which shifts the type of return profile, risk and diversification characteristics for investors.

A key argument in favour of the inclusion of smaller and medium sized companies is their stronger performance over time. Over the past five years, the FTSE 100 is 36.6% (Source: FT, to 29 June 2015). Over the same period, the FTSE 250 (ex Investment trusts) index is up 83.9%. Smaller companies have also shown strong performance, just marginally behind the mid-cap index.

Could this outperformance simply reflect a rosy period? Or is there something more at work? It should be noted that the FTSE 250 has also outperformed the FTSE 100 since the turn of the century (http://moneyweek.com/ftse-100-v-ftse-250-why-have-they-diverged-by-so-much/), so it suggests that there is a structural strength to this part of the market. It has been argued that medium-sized companies tend to be in a growth ‘sweet spot’, large enough to be at low risk of failure, but small enough to be able to deliver meaningful growth.

Equally, the mid-cap sector can be more dynamic. A number of new and exciting companies have listed on the stock market over the past 18 months, including AA, AO.com, Auto Trader and Whizz Air. The majority have come to market as mid cap stocks with relatively few companies new to the market large enough to be part of the FTSE 100 immediately. These companies are in new and exciting sectors, and may have strong growth momentum. An investor in the All Share would participate, while an investor in the FTSE 100 would have to wait until they grew large enough, potentially after their growth has slowed.

That said, investing in these parts of the market can be volatile. These sectors of the market may have bounced back strongly after the Global Financial Crisis, but it was extremely uncomfortable for investors during the immediate aftermath of the Lehmans’ default. Historically, larger capitalisation stocks have proved more defensive at times of market dislocation and as such, should provide ballast to a portfolio.

Investing in both large and small companies will also give an investor access to a greater variety of sectors, building a more diversified portfolio. The FTSE 100 has around 30% of its weight by capitalisation in just the oil and gas and banking sectors. Healthcare is also heavily represented, as are heavy industrial and natural resources companies. (http://www.ftse.com/Analytics/FactSheets/Home/FactSheet/Regions/MCAP/1/EUR/1 – select ‘FTSE 100’)

There will be times when it is right to invest in this type of company. For example, healthcare companies can prove defensive when the economy is weak because demand for their products is not particularly sensitive to consumer confidence. However, the FTSE 100’s weighting towards commodity-sensitive companies has proved a hindrance more recently as the price of oil and other commodities has sunk.

The introduction of small and medium-sized listed companies varies this sector exposure a little more. For example, the FTSE All Share has higher weightings in consumer goods and services companies. 14.52% and 11.76% respectively, which introduces greater exposure to UK consumer spending. It also has higher weightings in areas such as technology, travel and leisure, and real estate.

Incorporating smaller and medium-sized companies may also vary the geographic balance of a portfolio. The FTSE 100 is heavily skewed to the largest global companies – BP, Vodafone or GlaxoSmithKline. While we might see these as British companies, their fortunes are more tied to the strength of the global economy and the trajectory of their earnings will have little in common with the fortunes of the UK economy.

The mid and small cap sectors will tend to have more domestically-focused companies – companies such as housebuilder Berkeley, or high street stalwarts Greggs and Halfords. This is not necessarily a good or bad thing, but it may mean that if investors are looking for a UK fund to give greater UK exposure, then an All-Share tracker is likely to provider that. At the moment, when the UK economy is strong, investors have been keen to incorporate more domestic exposure. Either way, incorporating both types of company into a portfolio gives a better balance over the long term.

It should be said that both the FTSE 100 and All Share offer an attractive dividend yield – currently over 3% – though the yield on the FTSE 100 is marginally higher.

The Aberdeen UK Tracker trust is designed to track closely the performance of the FTSE All-Share. We believe that using this broader benchmark enables investors to achieve greater diversification, while still participating in the higher growth sectors of the UK economy.

 

The value of investments and the income from them can fall and investors may get back less than the amount invested. Please remember that past performance is not a guide to future results.

A full list of the risks applicable to this investment trust can be found in the factsheet which is available at www.aberdeenuktracker.co.uk.