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The Observer: Overweight in London? How to slim down

The Observer: Overweight in London? How to slim down

Heather Connon

Sunday June 12, 2005

Being overweight is not just a worry for idle teenagers guzzling junk food – it’s also an issue that should concern investors. London’s indices have become alarmingly top heavy: a decade ago, the top five stocks represented just 15.3 per cent of the All-Share index and the largest company accounted for 3.5 per cent. When Royal Dutch Shell moves its full listing to London in the summer, the weighting of the top 10 will have jumped to more than 41 per cent, while the biggest – oil giant BP – will represent more than 8 per cent of the index on its own.

Such a high concentration means the indices are heavily dependent on the performance of just a few companies and sectors – oil, banks, telecoms and pharmaceuticals account for well over half the index.

Investors in tracker funds are, on the face of it, most exposed because they are designed to mirror the index exactly. Thus the trackers followed the technology boom up, buying up the likes of Vodafone and, worse, Baltimore, as technology fever catapulted them into the FTSE 100, then down again as the boom evaporated.

Active fund managers were badly hit too, particularly ‘closet indexers’ who slavishly follow the FTSE 100 or All-Share instead of risking bets that could go wrong.

Closet indexation has become less fashionable of late, at least partly because it has produced such a lacklustre performance. While the FTSE 100 and the all-share, which mirrors the FTSE’s performance, are both more than a fifth below where they were five years ago, the FTSE 250 index of medium-sized companies is up more than 10 per cent over the same period. But investment managers will often be barred from veering too far away from a sector or individual company.

The result, says Robert Talbut of Royal London Asset Management, is that they end up buying the high priced shares, with the heavy weighting, and not the cheap ones, which are under-represented in the index.

Pension funds and other institutions have become alarmed both about the concentration of the indices and the consequences for fund manager behaviour. FTSE, the company that produces the index, is finally recognising these risks too. A week tomorrow, it will launch the FTSE cap 100 5 per cent and the FTSE cap All-Share 5 per cent indices which, as the names imply, will limit the weighting of any company to a maximum of 5 per cent. The components will remain the same as in the uncapped indices, but the weightings of those below the 5 per cent limit will be adjusted upwards accordingly.

Legal & General is already planning to offer its biggest institutional clients a choice of this and any other capped index they think appropriate – there is, after all, nothing magic about 5 per cent – and Talbut expects other firms to move away from the traditional benchmarks.

In the retail market, City of London Investment Trust got there first, replacing the All-Share with an index capped at 4 per cent for its benchmark. Trust chairman Simon de Zoete said he felt the All-Share had simply become too risky. ‘Who knows – BP could become another Enron,’ he said in reference to the collapsed US energy giant. Over the past five years, City of London’s capped index would have beaten the all-share index by 6.44 per cent, helped, no doubt, by the unpopularity of big companies. But David McCraw, head of structured products at Aberdeen – which offers a range of trackers – points out that, if sentiment changes, a capped index could miss out on some of the upside.

So far, however, there is no sign of retail products to track capped indices. McCraw says mimicking the capped indices would be too complicated, requiring daily adjustments to the portfolio.

Active fund managers such as Fidelity and Invesco Perpetual, which pride themselves on stock picking, claim they already ignore index weightings and buy where they see value. Not all managers do what they say, however: if the largest shares in the funds in your portfolio are BP, Vodafone, HSBC and GlaxoSmithKline, beware: you could have a closet tracker in your portfolio, and should be aware of the risks.

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