Equity tracker funds - incomes under threat

Graham Ashby, Head of Retail UK Equities at Credit Suisse, warns investors that UK equity tracker funds are increasingly exposed to the Oil & Gas and Mining sectors and levels of income are under threat.

FTSE International just announced its quarterly changes to the composition of the FTSE 100 Index, including the entrance of two new resources companies: Ferrexpo and Petrofac. This takes the number of Mining constituents in the FTSE 100 Index up to ten, with a further seven in the Oil & Gas sector.

In addition, there are now four Mining and three Oil & Gas companies in the top ten by market capitalisation. As these companies collectively account for 50% of the FTSE 100 Index’s total market capitalisation, there is an increased concern that investors in UK tracker funds are heavily exposed to what have historically been very cyclical industries.

At the end of March, UK tracker funds had £24.5bn of funds under management and accounted for nearly one third of net retail inflows over the previous quarter. Index trackers have often proven to be popular with investors due to low annual charges, and have recently performed better than many actively managed funds by buying into the ‘hot’ commodity areas of the market. Tracker funds also typically have less exposure to mid- and small-cap stocks which have underperformed over the past eighteen months.

However, the disadvantage of tracker funds is that, as their investments are pre-determined by the makeup of the index they track, they do not always offer investors enough diversification and, as is the case currently, can be over exposed to certain sectors of a cyclical nature.

Commenting on these findings, Graham Ashby, Head of Retail UK Equities said: “Index trackers are an important part of investors’ portfolios and offer a cost-effective way to gain exposure to the UK equity market. However, I am increasingly concerned that many investors and advisors recommending these funds do not fully appreciate how concentrated their exposure to certain industries is becoming. It’s telling, for example, that the top ten stocks in the FTSE 100 Index now includes just one Pharmaceutical stock, one Telecoms company and one Bank – the rest are all in the Mining or Oil & Gas sectors.

“Index trackers will also be major participants in the raising of additional equity by the Banking sector, even though many of these stocks are going to pay a much lower level of dividend than in the past. Unless dividend growth in other parts of the market accelerates, this could mean the yield on offer from index trackers falls.

“Investors looking for a more diversified UK equity portfolio and a more secure income stream should therefore consider reducing their exposure to index trackers. The solution, however, is not to buy an actively managed fund which is simply an ‘index hugger’ but charges a higher fee.

“Our solution at Credit Suisse is simple. We do not believe it is appropriate to slavishly follow the composition of the FTSE 100 or FTSE All-Share Index, and instead aim to provide diversified portfolios for our clients in good companies across the UK market spectrum. We also believe that every stock in the portfolio should make an impact upon performance, and set target minimum and maximum holdings regardless of the index weighting. We believe this approach will provide investors with above average returns combined with a secure income stream over the longer-term.”