Index trackers take a very active view

As the FTSE reshuffle this week told a tale of our times, index investing involves sticking with the winners.

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  1. Charles Stanley

An equity index is a moving portrait of the economic health and direction of a nation or economic area. Each quarter, the compilers of the main indices of the world make changes to their Index composition. The FTSE 100 in the UK holds the 100 largest UK-quoted companies. The S&P 500 holds the 500 largest US names. At the quarter end, out go the less successful companies whose market values have been falling, and in come replacements whose share prices and market values have been rising.

This time the changes to the FTSE 100 index removed three companies damaged by the Covid-19 crash, and one that is on the wrong side of the green divide. Both easyJet and Carnival offer holidays by air or by cruise liner. Their businesses have been temporarily stopped by the bans brought in to control the pandemic. There are doubts about how long it will take to get their business back. Have their markets have been sentenced to a less prosperous future as pressures intensify against fuel-hungry travel for pleasure and as some people worry about the risks more?

Meggitt has dropped out, also damaged by the changes in aviation. Producing high-grade engineered products for planes, it faces fewer orders from the civil side of the airline industry for some time ahead. Centrica, the gas supplier has also been demoted. Whilst it is still an important utility supplying a lot of heating and energy to people's homes, it has been disadvantaged by the fall in oil and gas prices and by the strong policy thrust to reduce our dependence on fossil fuels.

A reflection of the turbulent times

These changes are a perfect cameo of our times. The companies coming in include two winners from the Covid-19 revolution. Avast is a cyber software specialist at a time when many people are adding to their home computing capacity and strengthening security, and when businesses are equipping many more people to work remotely from home.

Homeserve is a company that services and repairs domestic equipment, which should have plenty of work now so many more people are spending so much more time in their own properties. The return of Ladbrokes, owned by GVC, and the promotion of Kingfisher are two more traditional businesses. They too are clearly getting some benefit from current straightened circumstances. Kingfisher has now reopened its B&Q stores and is doing a good trade as people kept at home decide on some DIY. It appears online gambling too can help pass the time.

The FTSE 100 Index was first established in 1984. Only one-quarter of the businesses that were in it on 3 January that year are still with it today. Some have been taken over for a good price. Some have closed or gone bankrupt. Some have drifted down the size league owing to trading difficulties. The big building supply companies, RMC, Redland, BPB and Blue Circle were all acquired by foreign interests and left the Index.

Big retailers such as Boots, Marks & Spencer, GUS and Burton were also changed by deals or outpaced by new businesses and sectors that could grow their wealth faster. The UK's once world-dominating textile industry was still represented in the Index by Courtaulds, but European and Asian competition was undermining the great companies quickly.

English China Clays and Pilkington Glass were important UK industrial champions that have since been taken over. The UK's fairly new oil province in the North Sea was reaching full production and adding greatly to UK wealth and income. Britoil, a recently privatised player, and Ultramar featured alongside Shell and BP in the 1984 Index to record the importance of this sector.

Special type of active

These changes are a reminder that if you buy an index tracker you are buying a special kind of active manager. In the case of a share index that requires companies to reach a given level of capitalisation to be included, the index manager is a momentum investor, backing success and selling shares when a company starts to falter.

The equity index manager is on the constant look out for companies that have better business models and bigger fan clubs, to substitute them for the complacent or the struggling giants of yesterday that would otherwise linger in the Index. The adjustments usually occur every three months when companies are promoted or relegated like a football league. Every day the market trades the index fund also reflects success and failure in the amount of any company held. If someone buys new units in an index fund the manager buys in exact proportion to the value of the shares in the Index. The ones that have done badly will be a falling percentage of the total invested and the ones doing well a rising proportion.

In this way, index-tracking daily backs fashion and success and condemns unpopularity and troubles. The Index keeps itself up to date with the huge changes underway in the underlying economy. The FTSE 100 has ridden the oil boom, handled the manufacturing contraction, and is now responding to the digital and green revolutions. In 1984 few would have predicted the exit of ICI, the UK's chemicals conglomerate, or of Marks & Spencer, a leading retailer, from the new index. Both duly left as the world changed.

This leads us to an interesting conclusion. An index fund is run by two managers, the manager of the index changes and the manager of the fund that rebalances. Taken together these funds are not passive. In the case of indices, with restricted numbers of shares based on capitalisation, it is an active approach. Companies on the slide are sold early in their falls, whilst new investment is made in success. The fund will run all its successes, without taking profits when they are riding high. Sometimes this results in continuing great wins, as some companies can string together many years of dominance. Sometimes it means the fund then sees some of the gains lost. If you wished to name the style of investing you could call it popularity investing, sticking with winners.

Nothing on this website should be construed as personal advice based on your circumstances. No news or research item is a personal recommendation to deal.

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