Investing In The FTSE 100: How, Why And Why Not

The FTSE 100 is the UK stock market’s most popular index among investors – both retail (private individuals) and institutional investors (banks, pension and insurance funds etc.). It’s comprised of the 100 largest companies by market capitalisation (combined value of all shares issued by the company) listed on the London Stock Exchange (LSE).

Constituents of the FTSE 100 include well know British companies such as the major banks like Barclays, Bank of Scotland and Lloyds, supermarket chains Tesco and WM Morrison, oil companies including Royal Dutch Shell and BP and utilities providers like BT, Centrica (formerly British Gas), Vodafone and Severn Trent. The London Stock Exchange itself, the company that runs the exchange, is a member of the FTSE 100, as are fashion chain Next and British Airways-parent International Airlines.

Here we’ll exchange exactly how an index works, why investing in indices like the FTSE 100 is so popular, the historical returns that an investment in the FTSE 100 would have resulted in, how exactly to go about investing in it and the alternatives investors should be aware of.

What’s An Index Like The FTSE 100 And How Do They Work?

A stock market index measures a particular section of the stock market. That could be a particular industry or sector such as retailers, manufacturers, finance, tech or construction. Or an index could measure a geographical region, like Europe, Asia or North America.  Or it can, like the FTSE 100, track a group of companies grouped according to size. An index is a, usually weighted, average of the performance of all of its constituents as a group.

Source: Schroders

The FTSE 100 is the index of the 100 largest companies listed on the London Stock Exchange. It is a ‘weighted’ index, which means the performance of each one of the 100 companies that make up the index will make up more or less of the overall average depending on the relative size of the company compared to the others. For example, BP’s market capitalisation is around £94 billion at the time of writing. The market capitalisation of fashion retailer Next is £9.6 billion. BP’s FTSE 100 weighting is, therefore, almost 10 times more than that of Next. If BP’s value rises or falls, that will have an approximately 10 times greater influence on the performance of the FTSE 100 than the value of Next rising or falling.

Because many of these large companies, often referred to as ‘blue chips’, earn a majority of their revenues internationally, and often own companies that are registered and operate in other countries, the FTSE 100 is a pretty good reflection of international economic events and conditions. Often it will drop in response to markets falling around the world. But around 25% of its constituents do also earn a majority of their revenues in the UK in pound sterling. As such the index also reflects domestic economic conditions.

The FTSE 100 is a useful performance benchmark for investors who buy shares in different companies. If an investor or investment manager running a portfolio made up of London-listed blue chip companies wanted to know how they were doing, they would use the FTSE 100 as a benchmark. If their portfolio was not doing better than the FTSE 100 index over an extended period of time, they would not have done a good job at selecting which company shares to invest in.

The FTSE 100 index has existed since 1984, when it was jointly established, and owned, by the Financial Times (FT) and London Stock Exchange (LSE). Its starting value was set at 1000.00, which has, as of December 2019, grown to 7273.47. That means the value of today’s largest 100 companies is over 700% more than the value of the largest 100 back in 1984.

The companies that now make up the FTSE in late 2019 are very different to the original 100 back in January 1984. The index is updated every quarter to make sure it still contains the largest 100 companies on the LSE. Which means as the relative size of all of the companies listed on the London Stock Exchange changed over the years as companies went through mergers and acquisitions, failed or grew, the 100 constituents have also significantly changed.

Why Invest In An Index Like The FTSE 100?

It is also possible to invest in the FTSE 100. Of course, an index is not a company so it’s not possible to literally buy shares in the ‘FTSE 100’. But an investment can still be made that will offer the same returns or losses as the index. That’s done through a financial security called an ‘index tracker’ fund. Index tracker funds simply buy a weighted number of shares in all 100 of the companies that make up the index. The fund’s performance then almost exactly mirrors the performance of the index. Investors by shares in the fund, which rise and fall in value as the index does.

Source: Schroders

But why invest in the average performance of the largest 100 companies on the London Stock Exchange? Why not choose which of those 100 to invest in based on a forecast of their prospects. That would, surely, lead to much better returns than an average dragged down by companies in the FTSE 100 that don’t look like they have a bright future and will probably lose value.

In theory, it would. The problem is, it turns out to be quite difficult to accurately predict which companies in the FTSE 100 will perform better than others over any extended period of time. Even professional fund managers, whose full time job and training it is to pick the winners and invest only in those rather than the whole FTSE 100 index, get it wrong more than they get it right. Numerous independent studies have shown that only a relatively small minority of fund managers consistently outperform the benchmark index, in this case the FTSE 100 but the statistics show the same general failure between other indices and active stock picking, consistently over time when fund fees are taken into account.

Yes, some actively managed funds do outperform their benchmark index consistently over a period of time. But most don’t. For many investors, the statistically higher chance of doing worse rather than better when either personally stock picking from the FTSE 100, or investing in an actively managed fund that does so, means they prefer to just invest in the benchmark index. Of course, others have enough faith in their stock picking ability, or that of their fund manager or investment advisor, to take the risk.

But the argument for investing in the index rather than trying to cherry pick the constituents that will perform best over coming years is a strong one.

Has Investing In The FTSE 100 Index Historically Provided Good Returns?

Of course, the first big question any investor should ask themselves before investing in the FTSE 100 is what kind of returns can be expected? Unfortunately, there’s no way of knowing how the FTSE 100 will perform in the future. But looking at past performance over an extended period of time can give some valuable insight. Financial market cycles do have a habit of repeating themselves over time.

Long term investors also include ‘compound returns’ when forecasting long term investment gains. Compound returns are returns based on re-investing any income generated by dividends back into the same security. Doing so can really boost overall returns over longer periods of time. For example, if the annual return from a FTSE 100 investment were 10% one year and 15% the next (those figures would represent two good years rather than a realistic expected average and are chosen for the sake of the example), total compound returns would not be 25% but 26.5%. The annualised return for each year would be 12.47%.

It’s important to estimate returns on a compounded annualised basis rather than simply adding gross annual returns together and dividing them by the number of years. For example, the FTSE 100 index closed -2.9% lower in December 2018 than it did in December 1999 – but if you include reinvested dividends, investors would have seen returns of +81.3% over the 19-year period. This is an annual return of 3.18%.

It’s also important to adjust for inflation over longer periods of time to get an idea what ‘real’ returns are. Over 120 years, the UK equities market has returned annualised compounded returns of 4.9% after being adjusted for inflation.

How Have FTSE 100 Investments Performed Over Time?

There are many different factors that converge to impact the performance of the FTSE 100 over time. Those include geopolitical factors, the wider global and domestic UK economy, monetary policy of the Bank of England and less tangible influences such as news and investor sentiment. They all affect industries and individual companies differently.

FTSE 100 returns vary over different time periods. Let’s look at some historical windows of the index to see how it has done over different points in history.

FTSE 100 Over The Last Five Years

The annual return over the past five years was 3.9% with dividends reinvested, despite annual returns being mixed, with a range from a low of -1.3% to a high of 19.1%, adding up to a total return of 21%.

FTSE 100 Over The Last Ten Years

Over the past 10 years, the compound return was 8.8% per annum, which is around average once inflation is taken into consideration. That adds up to a total compound return of 121% over the whole decade. The period benefited from the recovery after the 2008 financial crisis that saw the FTSE 100 drop to its lowest level since 2003. But a strong recovery saw the index move to its highest ever levels. Investors with a long term outlook should remain calm during stock market downturns as, at least historically, the subsequent recovery has always seen losses recovered before the index has usually move on to new heights. As long as investments don’t have to be sold in the meanwhile, investors can sit tight and wait for the storm to pass.

FTSE 100 Over The Last Twenty-Five Years

Over the last 25 years, the FTSE 100 has delivered compound annual returns of 6.4% when adjusted for inflation. That adds up to a total return of 375%, demonstrating the power of compound returns over a long period of time when dividends are reinvested.

How Do I Invest In The FTSE 100?

A direct, long term investment in the FTSE 100 is made through low cost exchange traded tracker funds called ETFs. Because these funds involve no active management, and are just adjusted to track the FTSE 100 index as its weightings and constituents change over time, the fees they charge investors are a fraction of those common to actively managed funds.

Short term traders also invest in the FTSE 100. They do so through CFDs, that allow them to take advantage of smaller, short term price movements of the index by using leverage to multiply gains. That does, however, mean losses are also multiplied if they occur. Because the effective use of leverage, and that short term index movements are hard to predict, trading CFDs is only suited to experienced investors who know what they are doing.

Alternatives To Investing In The FTSE 100?

As we are always keen to stress, investors should diversify their portfolios to give them the best chance of achieving a strong risk to potential returns ratio. While investing in the FTSE 100 offers inherent diversification because the index is made of 100 constituents, investors can, and probably should, diversify further.

That can be cheaply achieved by investing in other indices alongside the FTSE 100. In the UK, the FTSE 250 offers a more UK-economy focused and well diversified way to invest in the London Stock Exchange. The FTSE All-Share index covers the entire London Stock Exchange proper (excluding AIM stocks only), so combines the FTSE 100, FTSE 250 and smaller stocks for large, mid and small-cap exposure.

Outside of the UK, investors can opt for the major Wall Street indices for exposure to the U.S. economy. The Nasdaq has a heavier weighting towards the large tech companies and S&P 500 offers a broader cross-industry snapshot of the U.S. economy. There are also indices which cover other countries or broader geographies, such as Japan, China, Asia, Europe, Emerging Markets and others. And there are also indices that cover particular sectors and indices such as tech, biotech, manufacturing and the list goes on.

Investors are increasingly realising the benefits of the low-cost, broad diversification that index investing offers them. The FTSE 100 is a popular starting choice for many.