Underweight on business


Why not diversify by buying a tracker fund? Because what is representative of the stock market is not at all representative of the British economy.

Everyone knows that the lowest risk way of buying equities is simply to buy the index. That is why passive fund management has become so popular, and why the government has favoured tracker funds in promoting its individual savings accounts.

And yet, as so often in business economics, what everyone knows is not necessarily true. When you buy the index you buy a very particular selection of firms and industries. Half the market capitalisation of the FTSE-100 today is made up of financial services businesses, pharmaceutical companies, and telecoms operators. And yet these activities taken together account for less than 10% of economic activity in Britain today.

Now it is true that these sectors are expanding rapidly. But only a little doodling on the back of an envelope will satisfy you that however fast they grow these sectors will never matter as much to the Office for National Statistics as they do to the Stock Exchange. What is representative of the stock market is not at all representative of the British economy.

Is it that financial services pharmaceuticals and telecom services are simply more profitable than other business activities? Today, this is true. Returns on capital employed in these activities are higher than the average for industry as a whole, and way above long term interest rates. But basic principles of business economics assure you that it is impossible for some industries to be permanently more rewarding than others. In the absence of monopoly – and there is no longer monopoly in any of these industries – competition and entry will force down returns in line with earnings elsewhere.

Now the British economy is by no means congruent with the activities of British companies. Much of what is done by the new BP Amoco, or the expanded Vodafone, never touches British shores, Glaxo Wellcome sells most of its products abroad. And this cuts both ways. If you want to buy into the British motor industry today, you will need to own shares in Ford, BMW, Nissan and Toyota. So we can’t expect the composition of the two measures to be exactly the same.

But the main reason for the discrepancy is that the industrial composition of the index is very different from the industrial composition of all economic activity in Britain as a whole.

Table 1

What you get Share of FTSE-100 market cap Share of national income

Financial services 25.5 6.4

Pharmaceuticals 13.3 0.6

Telecoms 11.6 2.9

Oil 8.3 2.2

Electricity, gas, water 6.2 2.3

64.9 14.4

What you don’t

Health and education 0 10.9

Construction 0 5.1

Property 0.4 19.7

Retailing 6.3 11.7

Transport 2.5 5.5

9.2 52.9

Sources: Lehman Bros; Office for National Statistics

Public ownership is much less extensive than it was, but the government still dominates education, health care and public administration. You can own shares in Nord Anglia, CrestaCare or Capita – none of them in the FTSE-100 – but these activities are still hugely under-represented in the market.

And there are wide divergences within the privately owned economy itself. The stock market is biased towards large companies. There are few small banks, and no small integrated oil companies. The all-share index is slightly less unrepresentative than the FTSE-100. But this is not the main point. Since the top 100 shares make up 79% of the all-share index, the industrial industries covered by the two are very similar. The key issue is that some sectors are much more oriented to the stock market than others.

There is not much agriculture, or plumbing, or legal services in the FTSE-100. Construction, property and activities associated with them – building, owning and running houses, offices, warehouses and shops – account for about a quarter of economic activity in Britain. But there is only one property company, and no construction firm among the 100 largest businesses, and these sectors now account only for a very small part of total market capitalisation.

Now you could use the stock market to buy a selection of stocks which was more truly representative of the British economy. Such a portfolio would be underweight, relative to the index, in banks and pharmaceuticals, and more heavily invested in construction, property and health care. And if, as a foreign investor, you have made a decision to invest in Britain in order to diversify your global portfolio that is exactly the portfolio you should have. As we know, the bias of most overseas buyers is exactly the opposite.

But rather than search for the Holy Grail of the true index, we should ask deeper questions about the nature of investment. Investing passively is not the same as minimising risk. Unless the risk you minimise is the risk of not matching the index – which may be true for many fund managers and trustees. But while this may be the objective of the money manager, the objectives of those whose money they manage are and should be different. They are concerned with absolute, not relative, risk and return. Minimising risk, or obtaining the most efficient trade-off of risk and reward, is about diversification. And a portfolio of the stocks of large quoted British companies has ceased to be in any way diversified, as a result of the herd instinct of capital markets and business leaders. Today it consists of a group of similar companies, with similar management styles, similar aspirations, and similar strategies, increasingly concentrated in three or four global industries.

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