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How Falling Commodity Prices have Rebalanced the FTSE 100

The commodity crash and ongoing hunt for yield have radically altered the nature of the FTSE 100, turning it into a much more balanced bet

Hortense Bioy, CFA 13 April, 2016 | 12:10PM

The FTSE 100 has been a notable laggard over the past five years, underperforming the S&P 500, its US large-cap equivalent, as well as the UK mid & small cap FTSE 250 by 6% and 6.2% in annualised terms, respectively.

Traditional indices constantly evolve through time according to different fundamental drivers

Most of this underperformance can be easily explained by the FTSE 100’s heavy concentration in the resources sector, energy and mining companies, which post-financial crisis grew to become the index’s top sector, with a weighting of over 30%, supported by the voracious appetite of emerging markets. Companies like Royal Dutch Shell (RDSB) and Rio Tinto (RIO) have since been hit hard by a slowdown in China, compounded by the collapse in the price of oil and other commodities. As a result of their deflating valuations, energy and basic material stocks account today for less than 13% and 6% of the index value, respectively.

Meanwhile, consumer defensive stocks, including British American Tobacco (BATS), Reckitt Benckiser (RB.) and Unilever (ULVR), have seen their share price surge and their index weight increase. Today the consumer defensive sector represents about 20% of the FTSE 100, up from 15% five years ago. It has become the index’s second largest sector, behind financials at 21%.

The higher valuations can be justified by the good operational performance of the underlying companies, but perhaps not entirely. The search for yield and safety in the prolonged low interest rate and volatile market environment has led to increased demand for high-yielding and stable stocks, with consumer staples perceived as a safe bet.

Another sector that has seen its representation in the FTSE 100 increase over the past few years is consumer cyclicals. Helped by low interest rates and the UK’s relatively strong domestic recovery, the sector now makes up 10% of the index, double what it was five years ago, and at par with healthcare.

Is the FTSE Now More Attractive to Investors?

Some would argue that, as currently constituted, the FTSE 100 appears a better balanced and more diversified benchmark than it was five years ago. In sum, closer to what one would class as a truly broad-based investment proposition. It certainly is if compared to the pre-crisis era when banks pushed the index’s exposure to financials to over 40% of its market capitalisation, or even if compared to the late nineties, when the index was overexposed to telecom and technology companies.

That said, the current composition is bound to be temporary. And ultimately, although it is often cited as a bellwether for the UK economy and used as a barometer of investor sentiment about the UK stock market, the FTSE 100 remains a very global benchmark, with more than 70% of its revenues coming from abroad.

Still, these changes in composition should serve as a reminder to investors, especially those investing passively through ETFs or index funds, that market-cap-weighted indices such as the FTSE 100 are not static; quite the contrary, in fact. Because they self-rebalance, traditional indices are dynamic creatures which constantly evolve through time according to different fundamental drivers. For that reason, it is crucial that investors assess whether the bet they have made fits in with their investment objectives at any given time.

This article originally appeared in International Adviser magazine

The information contained within is for educational and informational purposes ONLY. It is not intended nor should it be considered an invitation or inducement to buy or sell a security or securities noted within nor should it be viewed as a communication intended to persuade or incite you to buy or sell security or securities noted within. Any commentary provided is the opinion of the author and should not be considered a personalised recommendation. The information contained within should not be a person's sole basis for making an investment decision. Please contact your financial professional before making an investment decision.

About Author Hortense Bioy, CFA

Hortense Bioy, CFA  is director of passive fund research in Europe.