Buying The FTSE Is Stupid

Published in Investing on 6 September 2011

Why do-it-yourself index trackers don't work.

The other day, I wrote an article advocating the use of index trackers and index tracking ETFs as a type of defensive share.

The logic? Given the practical difficulties of picking individual defensive shares, index trackers at least hold out the promise that you won't -- costs and tracking error apart -- do any worse than the index in question.

But a reader's comment made a point that I've seen made several times before.

And it's this. Why buy the FTSE via an index tracker, when you can cut out the middleman and buy the individual shares?

Obvious appeal

In theory, it's a great idea. And it's certainly a point I've made myself, in respect of a few high-profile (and high-cost) investment funds that are little more than closet trackers.

With a lot of their investors' money parked in a dozen large FTSE 100 shares, these funds charge eye-watering fees. And, make no mistake, they're certainly an instance where investors could genuinely cut out the middleman, and buy the same dozen shares themselves.

But that's a very different proposition from a do-it-yourself index tracker.

£10,000 to invest

Let's say that you want to hold £10,000 in your very own do-it-yourself index tracker.

Even at the upper end of the FTSE 100, the idea quickly breaks down. On today's prices, for instance, you'd invest just £678.15 in the FTSE 100's largest share, HSBC (LSE: HSBA), which makes up 6.78% of London's flagship index.

Similarly, you'd buy £611.60 of the next-highest ranked share, Vodafone (LSE: VOD); and then spend £524.79 acquiring a stake in oil giant Shell (LSE: RDSB).

After that, it starts to get a bit silly. By the time you've built stakes in the FTSE 100's ten largest shares, you're plunking down £286.45 for the privilege of owning a piece of AstraZeneca (LSE: AZN), for instance.

These aren't big stakes by any means. And each one is incurring you brokerage fees and stamp duty. In short, costs quickly start to mount up.

And down at the bottom end of the FTSE 100, your broker's fee and stamp duty are likely dwarfing the size of the stake you're buying. £4.96 of Schroder's (LSE: SDRC), anyone? £6.96 of Essar Energy (LSE: ESSR)? Or £8.59 of Hargreaves Lansdown (LSE: HL)? No, that's just stupid.

£100,000 to invest

But surely, then, the principle of the do-it-yourself index tracker works with a bigger investment pot? Such as £100,000?

Not really. Down at the bottom end of the FTSE 100, it turns out that you're still buying stakes of less than £100.

Even in the middle of the FTSE 100, you're spending less than £400 to buy into business like Kingfisher (LSE: KGF), Smith & Nephew (LSE: SN) and International Power (LSE: IPR).

Tracking error

Only in the FTSE's top ten shares are your investments coming to more than £4,000 each.

Restrict yourself to that subset of shares, and spend your entire £100,000 on just those shares, and you'll certainly cut your investment costs. Just ten lots of commission, in short, and ten lots of stamp duty to pay.

On the other hand, you'll have embraced just 46% of the FTSE 100, leaving you massively exposed to tracking error. And also leaving you with an investment pot that contains six oil and mining shares -- plus a bank, a telco, a tobacco business and a pharmaceutical firm.

Balanced and diversified? Not exactly.

And a not dissimilar picture emerges if you expand the investment universe to the top 20 shares. Your average stake drops to £3,366 or so, and a few consumer shares such as Tesco (LSE: TSCO), Diageo (LSE: DGE) and Reckitt Benckiser (LSE: RB) come into the frame. On the plus side, though, you've captured 67% of the FTSE 100.

Buy a tracker, not an index

All of which tends to make low‑cost index tracking funds from providers such as Vanguard, HSBC or Fidelity look remarkably good value. Vanguard, let's remind ourselves, has a TER of just 0.15%, with HSBC coming in at 0.27% and Fidelity at 0.3%.

Or, in the shape of individual shares that you can tuck in your portfolio, index‑tracking ETFs such as the HSBC FTSE 100 ETF (LSE: HUKX), or iShares' FTSE 100 ETF (LSE: ISF). HSBC's ETF costs you just 0.34%, while the iShares product is a tad more expensive at 0.4%.

Try beating those charges with a do-it-yourself index tracker.

Looking for other index-tracking investment ideas? My colleague Padraig O'Hannelly's round-up of the cheapest trackers admittedly pre-dates the arrival of low-cost specialist Vanguard -- and HSBC consequently slashing its charges in response -- but is otherwise spot on. Happy hunting!

More on the markets:

> Both Malcolm and The Motley Fool own shares in AstraZeneca, Tesco, and Reckitt Benckiser. Malcolm also holds index trackers with Vanguard and HSBC.

> Worried about the state of the markets right now? Then get the Fool's latest free guide - What To Do When The Market Plunges

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Comments

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MF09 06 Sep 2011 , 3:37pm

Stamp Duty is a fixed percentage, so the duty on 100 trades of £100 would be the same as 1 trade of £10,000 - implying that making several smaller trades therefore increases the cost because of stamp duty is totally misleading...

MDW1954 06 Sep 2011 , 3:42pm

Hi there MF09,

I've re-read it carefully, and I don't think it does imply that -- apologies, anyway, if that's the way you read it. I mention stamp duty just to make the point that I hadn't forgotten it.

Malcolm (author)

ProfessorMarcus 06 Sep 2011 , 3:47pm

Re:

On the other hand, you'll have embraced just 46% of the FTSE 100, leaving you massively exposed to tracking error. And also leaving you with an investment pot that contains six oil and mining shares -- plus a bank, a telco, a tobacco business and a pharmaceutical firm.

Balanced and diversified? Not exactly.

This demonstrates that the FTSE100 isn't very diversified or balanced even if you're tracking the entire index.

You'd be better with an All-Share tracker?

MF09 06 Sep 2011 , 4:00pm

Malcolm,

I was referring mostly to these two sections:

"And down at the bottom end of the FTSE 100, your broker's fee and stamp duty are likely dwarfing the size of the stake you're buying. £4.96 of Schroder's"

and

"just ten lots of commission, in short, and ten lots of stamp duty to pay."

Just seemed to me to be trying to make out that somehow the stamp duty on such a small purchase is somehow prohibitive (as it would be for the dealing fees) in the first case, and that ten lots of stamp duty is also a bad thing in the second case.

Maybe it's just me.....

MDW1954 06 Sep 2011 , 4:25pm

Hello ProfessorMarcus,

FTSE 100 index makes up around 80% of the FTSE All-Share, so there's not a lot to be gained. Even so, that's why I opt for the All-Share and not the FTSE 100.

Malcolm (author)

ProfessorMarcus 06 Sep 2011 , 4:31pm

Thanks Malcolm.

rober00 06 Sep 2011 , 4:38pm

Research seems to show that if you divesify with much more than 20 shares, the result will match the index. Apparently what shares they are does not matter.

In which case the calculations you make appear irrelevant.

MDW1954 06 Sep 2011 , 4:49pm

Hello rober00,

Following that logic, tracking error wouldn't exist at all. And I have to say that I haven't seen such research. Do you have a source you can cite? I'd certainly like to read it.

Malcolm (author)

MunroMan 06 Sep 2011 , 7:10pm

Buying individual shares may also create a CGT issue which is less likely with a collective.

Moreover it is easier to put additional funds into a collective rather than adding money to individual shares bit by bit.

Don't forget corporate actions either. Capital returns from company such as rolls Royce and Melose all have to be dealt with as well as takeovers and rights issue.

jaizan 06 Sep 2011 , 8:36pm

Research also shows value stocks outperform over the longer term. So why even try to track the index?

It should not be difficult to construct a portfolio of low PE shares, from a variety of sectors to reduce the risk.

DIYIncome 07 Sep 2011 , 8:37am

Buying an index tracker is like saying: "I don't mind if it goes up or down - at least I'm no better/worse than all the other s who are doing the same".

Not for me to float around like that. I may not do any/much better but investing for income will help me be patient over the next 2-3 years while the markets churn around in continued deression.

TomJefs 07 Sep 2011 , 9:29am

DIYIncome:

"Buying an index tracker is like saying: "I don't mind if it goes up or down - at least I'm no better/worse than all the other s who are doing the same"."

I don't know anyone who thinks like that. It is all about returns not about what joe bloggs is doing. As an index tracker holder my perspective is that I have a well reasoned view that either stockmarkets go up in the long or very long term or that dividends will ensure my returns are solid, especially after compounding.

The weight of research is against you if you think you can beat the market year in year out. Most fund managers don't so it is highly likely you won't either.

TomJefs 07 Sep 2011 , 9:32am

DIYIncome:

The start of your last sentence was a giveaway," I may not do any/much better". Oh dear. :)

mackeson29 07 Sep 2011 , 1:30pm

I imagine, most people with index trackers (like myself) use them to drip feed money into the market every month. Until TMF's monthly plan came along I don't think there was a cost effective way to do this outside of trackers. Another plus for them.

HighbrowNick 07 Sep 2011 , 1:52pm

I agree with DIY Income. If I buy a share in a company that I've researched, I have a good reason for believing that I will enjoy a good return on that share, based on the company's products, reputation etc.

If I buy into a tracker fund, I am taking a view that over time the stock market will do well. What's that based on? Maybe historically the stock market has done well, but it hasn't over the last ten years, and who is to say it will over the next.

Anyway, investing in trackers is no fun.

87crashdummy 07 Sep 2011 , 2:30pm

Hi Malcolm,

I use MF Sharebuilder as a longer term fund builder
only 1.50 a trade and no hassle, or management fees and i can invest when i want/can and for as little as i
lik, plus i can use the dividends to add to the share or buy new ones.
I cant recomend it enought for the small timeb long term punter!!
And for a change no MF adverts for the product!!

Dhahran2001 07 Sep 2011 , 2:57pm

What is so special about the FTSE 100? Answer, nothing except the size of the constituent companies. This seems a rather crude and simple criterion on which to base your diversification.

What is so special about 'the fund' with the smallest FTSE 100 tracking error? Nothing except its disproportionate cost of tracking.

Why not prefer shares in an Investment Trust, which is likely to be less expensive than a 'fund', where the holdings are weighted to achieve an objective that broadly suits you.

Slavish 'tracking' must almost certainly be a waste of (your) money.

Spode101 07 Sep 2011 , 4:09pm

I agree with TomJefs. Beating the Index consistently (without taking excessive risk by taking big bets on either market timing or single companies) is incredibly difficult. Research shows that there precisely the smae number of star fundamangers - those who consistently beat the index - as dunce ones, as would be in a random walk. And in any one year the dunce fund manager is as equally likely to out or under perform as the star. But we like to convince ourselves that it is our brilliant strategy that will lead a DIY investment policy to consistently outperform.

Do a rigorous analysis of your own performance. Rather than doing any market timing, stock or sector allocation plot your performance against that as if you simply invested in the Index each time you had the cash and left it there. (Don't forget to use the Div Reinvestments Index). Look at the key decisions that have affected your performance. Then take a good look in mirror and ask - can I really beat the Index over the long term, or I am just hoping to be lucky

geoff114 07 Sep 2011 , 4:13pm

Why not just open a spreadbet account and trade the actual FTSE 100 index, no commision, no fees, no tracking error, 0.8 spread, 3% margin, rollover financing charge of around 3% p.a., which is the same as taking the money out of your bank account earning 3%, you can drip feed money in (averaging down) by increasing your stake if the index falls, safe in the knowledge that the FTSE 100 index can't "go bust". I can't imagine why anyone would want to buy a tracker fund and pay for the privelege.

NCr70 07 Sep 2011 , 4:24pm

rober00 / Malcolm

20 is the number of shares at which investment-specific risk is nearly eliminated and beyond which you get diminishing returns from further diversification. You won't get the exactly the same performance as the index.

I don't have references to specific studies, but if I can quote from my CII course on this:

"Various academic studies suggest that 15 to 20 securities selected randomly are sufficient to eliminate most of the investment-specific risk in a portfolio. However...the rate of reduction diminishes as more securities are added."

I have no idea exactly what most means.

Spode101 07 Sep 2011 , 4:39pm

Geoff, are you sure this is a more cost efficient way than buying a tracker? Don't forget the trackers give you the div return on the Index (apprx 3%) as well as its capital movement

geoff114 07 Sep 2011 , 5:07pm

Spode, Sorry, forgot to mention that. You get an allowance every wednesday, (variable, depending which stocks have gone ex-div that day) eg. today's allowance was 7.05 points on the index. They do this by a notional reduction in the index every wednesday, so the index falls 7.05 pts without my long position losing any money. Over the year this equates to the FTSE 100 yield which, as you say, is around 3 to 4% .

Spode101 07 Sep 2011 , 8:45pm

Geoff, who do you use for the spreadbet? Sounds cool. Comments from other Fools?

peterfunfest 07 Sep 2011 , 8:48pm

Is it worth doing an assortment of UK trackers.

e.g. a mix of ftse100 and ftse250.

If so what would be a sensible allocation?

geoff114 07 Sep 2011 , 9:28pm

Spode, I use Spreadco, mainly because they only charge LIBOR+2% for the financing charge (so 2.63% at the mo.), and stop losses are not compulsory....never use them on an index....you can get stopped out at a loss on freak spikes/dips. You can set pending orders to buy below and sell above the current level. BTW the FTSE 100 dividend adjustment is usually published on Reuters each wed. and can be as much as 20odd points some weeks if a few big companies go ex-div on the same day.

Spode101 07 Sep 2011 , 11:37pm

Peter - Yes you can mix FTSE100 and 250 trackers. A FTSE all share tracker gives you exposure to the whole market based on capital weighting, but is naturally dominated by the FTSE 100. So if you want greater exposure to smaller companies buy a FTSE 250 tracker - allocation simply depends on your view that smaller will outperform bigger. Check out the history of performance - the 250 tends to get hit harder in a downturn but out performs in an upturn.

Geoff - thanks for the info - gonna check out if I can use spreadbetting more efficiently for my Index based allocation.

Also, does anyone know an ETF that tracks the German market (DAX). Just feel that it has been dragged down even further along with the EURO dogs (or PIIGS).

CELL0 09 Sep 2011 , 1:17pm

Intrigued as always. I'm an absolute rank amateur but optimist too.
Maths in school days suggested that when assessing statistics each of the first 9 data points showed improvement. After that it was minimal. Wiki gives some guidance on noise and signal so the techies amonsgt you could synthesize a model of significance.

Having naively asked what about holding the FTSE 100 components I'm grateful for the ensuing article and discussion.

Coming back to the real subject - investing - I'm now moving towards wanting income so my current bias is towards a HYP - thus matching all constituents of the FTSE 100 is not relevant. Also I have no interest in churn to match the FTSE make up but am interested in whether my high yielding shares will match the index. Statistically of course my sample isn't chosen at random so the data points are already skewed.

So holding say 10 shares with good yield should give me a reasonable income at low charges - I think a recent fool article suggested after a couple of years the self invested route was cheaper than a tracker. As my intention is to hang on for 10s of years then charges become (almost) irrelevant.
For me this is good income (at present and not bad in times of higher interest rates) combined with the potential for capital growth and not a bad alternative to an annuity with rates where they are. I may or may not beat trackers, funds, other experts but I retain control.

But... I cannot resist a bit of spice so have a few ETFs to expose me to the global bits of interest.

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