Tom Bailey explains why UK markets are out of form.
Since the big sell-offs in late February and March, stock market indices around the world have enjoyed strong rebounds. Some markets, however, have bounced back more than others, with the UK’s main indices notably lagging most other major indices.
Taken year-to-date, the FTSE 100 is down by around 18% (total return, as all indices cited will be). At the same time, the FTSE All-Share is also down by around the same amount.
In contrast, the S&P 500 is now up roughly 5% (in GBP terms, as all other indices cited will be). Meanwhile, Germany’s Dax is in positive territory for the year, with a return 0.76%, as is the MSCI All Country World index, with a return of 2.14%.
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Many other major indices are also still down, although performing significantly better than the FTSE 100. For example, the Eurozone’s Euro Stoxx 50 index is down by 6%, while France’s CAC 40 is down by 11%.
Here’s another way to show the underperformance of UK stocks: the MSCI All Country World Index, mentioned above, has a 2.14% positive return. If you strip out UK stocks, (the MSCI ACWI ex UK index), that return rises to 3.22%. That 108 basis point difference is due to the poor performance of UK stocks.
Why is this? The obvious answer is that it is a continuation of an already established trend. Ever since the UK’s Brexit referendum in 2016, the UK market has underperformed most other major markets around the world, on the back of fears about the potential economic fallout of Brexit.
It is true that the FTSE 100 is dominated by companies that make their earnings abroad in foreign currencies, meaning the index is somewhat insulated from a downturn in the UK economy. Even so, that has not been enough to counter a broader negative sentiment towards UK assets among international investors. Indeed, even if the decline in the value of the pound helps boost the earnings of FTSE 100 companies, a slide on sterling is also a risk to international investors buying stocks that are denominated in sterling.
According to Dan Nickols, head of strategy for UK small and mid cap at Jupiter Asset Management: “The ongoing Brexit drama means that, for overseas investors, the UK can simply be filed under ‘too difficult’ and ignored for now in favour of other equity markets.”
On top of this, sentiment towards the UK has not been helped by the economic fallout of Covid-19. According to latest figures, Britain’s economy contracted by a fifth in the last quarter, much worse than either the US or the eurozone.
However, the current underperformance of the FTSE 100 index is not explained by a continuation of negative sentiment to UK assets alone. The poor relative performance of the index is also largely “compositional”, meaning the sector weightings of the index itself help explain the FTSE 100’s poor performance. There is an important lesson for index funds or ETF investors here.
For example, as at the end of 2019, more than 20% of the FTSE 100 was in financials. That is significantly higher than for other major indices. For example, Germany’s Dax index ended 2019 with a 16% weighting to financials. Meanwhile, the S&P 500 had just under 13%.
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Banks have particularly suffered since the start of crisis for a variety of reasons, including increased fears about loan defaults and the broader drag that lower interest rates have on their ability to make money. In the case of the latter, the crisis has solidified a view that rates will not be increasing any time soon, dimming the future outlook for banks among investors.
The UK’s second-largest weighting at the end of 2019 was energy, which accounted for 14.39% of the index. This is the result of large oil producers in the index, such as Royal Dutch Shell (LSE:RDSB) and BP (LSE:BP.), among others. Again, this sector has had a torrid time since the outbreak of Covid-19. Alongside the slump in demand due to lockdowns and recessions, the price of oil was pushed down amid a brief price war between Saudi Arabia and Russia. All this has weighed heavily on energy shares and by extension the FTSE 100.
To gain a sense of how much this weighting has held back the FTSE 100 compared to other indices, we can compare it with the Dax and the S&P 500 again. At the end of 2019, energy stocks accounted for just 4.35% of the S&P 500. The German Dax, meanwhile, has no weighting towards energy stocks.
Compounding this, the FTSE 100 has a lower weighting to some of the year’s better-performing sectors.
Technology stocks, for example, have been the star performers so far in 2020. In part, this is owing to tech companies having business models that are seen as being more immune to the economic fallout of Covid-19, or in some cases even benefiting from it.
Unfortunately, the FTSE 100’s weighting towards information technology at the end of 2019 was a paltry 1%. In comparison, Germany’s Dax had a weighting of 13.6% to information technology stocks. And of course, the S&P 500 had a massive 23.2% weighting at the end of 2019, since surging to 27.5%.
A further example is healthcare, another sector which has benefited recently for obvious reasons. At the end of 2019, the FTSE 100 had a relatively healthy weighting to this sector, at just under 11%. However, that was still below the S&P 500 with its 14.6% and the Dax with its 11.4%. The difference here is not so vast, but combined with the other differences in sector weightings, adds up.
So, the important lesson here for any index investor is to understand the sector composition of the index that you are investing in.
It is well known that the FTSE 100 is dominated by firms that make their earnings abroad and is therefore not always influenced by the fortunes of the UK economy (although it still can be at times). But knowing that alone is not enough. Companies on Germany’s Dax also earn substantial amounts of their earnings abroad.
Instead, to understand why an index goes up or down it is vital to have an idea of the sort of businesses typically found in the index, and to understand which industrial sectors dominate the index and, therefore, which sectors you have exposure to. If investors in ETFs or index funds want to understand what it is exactly that they own, they need to look under the bonnet and get to grips with the index’s sector composition.
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