As someone who's from the UK and follows the financial independence movement I naturally started my investment journey by buying Vanguard's LifeStrategy Funds, which is over weighted towards the UK's home market, specifically the FTSE 100 Index. However, with the poor performance in this index I started to ask myself if it is better to invest in the FTSE 250 Index instead, and if investing in the FTSE is even worth it at all.
Since the start of the millennium the FTSE 100 is actually negative while the FTSE 250 has grown around 237%. You might assume that the FTSE All Share Index strikes a balance between the two and the rest of the UK market, but since the FTSE 100 is so large compared to the others it basically dominates the FTSE All Share Index and makes their performance roughly the same. By far, the FTSE 250 seems to be the best choice for UK market exposure and has managed to keep pace with the S&P 500 in the long run making it a very reasonable choice for your globally diversified portfolio.
What are the FTSE indexes?
FTSE stands for Financial Times Stock Exchange (renamed as FTSE Russell Group) and is a financial organisation in the UK that specialises in market indexes.
Most commonly known among these are the FTSE 100 Index - an index tracking the top 100 companies by market capitalisation on the London Stock Exchange (LSE) - and the FTSE 250 Index - the index that tracks the next 250 largest companies on the LSE after the first 100.
Launched in 1984 the FTSE 100 has a total market capitalisation of over £1.8 trillion as of May 2020, and currently counts among its constituents some heavyweight companies such as Shell, BP, GlaxoSmithKline, AstraZeneca, BHP Billiton, Rio Tinto, HSBC, and Barclays. As such, it is commonly used as the performance benchmark despite these large companies mostly being internationally focused and concentrated towards certain sectors.
8 years later in 1992 the FTSE 250 was launched and has a much smaller total market capitalisation by comparison at just under £400 billion as of July 2017. Despite the constituents being smaller in comparison to the FTSE 100 they are much more domestically focused and generally broader in terms of sector and industry, making it more proportionally representative of the overall market and therefore a more accurate barometer for the British economy.
Other FTSE indexes include the FTSE All-Share Index, the FTSE 350 Index (this is the FTSE 100 and FTSE 250 combined), the FTSE SmallCap Index, and the FTSE Fledgling Index.
How have they performed in the past?
The FTSE 100 started with a price of 1,000 and the closing price on April 1st 2021 is 6,737.30. This means that since inception the index has returned a total of 573% which would equate to an annual rate of return of around 5.255%.
By contrast, the FTSE 250 which started with a price of around 2,500 and closed at 21,732.67 on April 1st 2021 would have returned around 769%, an annual rate of return of around 7.891%.
Despite experiencing greater volatility and lower liquidity levels it appears that long-term investors have fared much better by putting their money into the FTSE 250 instead of the FTSE 100.
In fact, if you refer to the screenshot in the opening paragraphs of this article you will notice that the FTSE 250 has, with the exception of a couple of months in late 2008 to early 2009, outperformed the FTSE 100 since May 2006.
Author's note: I have no idea why but Google Finance only seems to go back this far in terms of data for the FTSE 250.
One thing to note it that since the FTSE 250 was launched 8 years after the FTSE 100, the latter has had an unfair advantage (even though it still loses) in terms of "time to grow".
If we do the calculations from the launch date of the FTSE 250, 12th October 1992, then the price of the FTSE 100 would have been around 2,563.90 meaning the total return from that date to present day would drop to 163%, or an annual rate of return of around 3.451%
In other words, the FTSE 250 has performed more than twice as well as the FTSE 100 since its inception.
What about dividends?
It should be noted that the average annual returns of the FTSE 100 (5.255% or 3.451%) and the FTSE 250 (7.891%) does not include dividends or dividend reinvestment.
The lower dividend yield for the FTSE 250 makes sense as it's more common or likely for smaller companies to be reinvesting their profits and earnings back into their growth. This is likely one of the reasons for the "smaller index" to grow so much quicker over the long run compared to its main counterpart.
Again using the 12th October 1992 as the starting point the combined annual average return for the FTSE 100 would be around 6.451% (3.451% + 3%) which is still far lower than the combined annual average return of 10.391% (7.891% + 2.5%) for the FTSE 250. A whole difference of almost 4%.
It would seem that the 0.5% of profits kept behind by the FTSE 250 has been put to very good use.
What about investing into the FTSE All Share Index?
If the FTSE 100 is mostly big international corporations while the FTSE 250 has medium sized, more domestically focused companies, then would a combination of these plus some of the smaller businesses in the London Stock Exchange be a better benchmark for the UK market and give you more balanced returns?
There does exist a FTSE 350 Index which is basically the FTSE 100 and FTSE 250 combined, but it doesn't include any other companies so wouldn't cover the smaller players, which is where you'd expect the most innovation and growth albeit with more risk.
The FTSE All Share Index looks to be the best fit for this description where it is an aggregation of the FTSE 100, the FTSE 250 and the FTSE SmallCap Index, and aims to represent the entire range of possible UK companies that are eligible for inclusion.
The FTSE SmallCap Index consists of the companies that rank from 351st to 619th on the London Stock Exchange in terms of market capitalisation.
By combining this with the FTSE 100 and the FTSE 250 - thereby getting the FTSE All Share Index - you would have an index that contains around 600 companies that is broadly diversified but very much focused on the UK's domestic market.
With more of the market covered, ensuring you're not missing out on the most important companies in the UK either large, medium or small, you would assume that investing into the FTSE All Share Index strikes a healthy balance between the performances of the FTSE 100 and the FTSE 250.
But... see the chart below:
Despite the FTSE All Share Index including many more companies, the size of the FTSE 100 in terms of market capitalisation is simply too great in comparison to the others.
Think back to the difference between the £1.8 trillion market capitalisation of the FTSE 100 and the £400 billion market capitalisation of the FTSE 250. The FTSE SmallCap Index by contrast represents approximately 2% of the UK market capitalisation.
While no specific number is given, Statista reports that the total market value of all companies trading on the LSE is around £3.67 trillion. If we take 2% of this then that would mean the FTSE SmallCap Index has a market capitalisation of approximately £73.5 billion.
Using these numbers it would mean the FTSE 100 actually represents around 80% of the FTSE All Share Index, resulting in their long term performance being much closer in alignment than what you would expect.
Yes, you would have exposure to more companies but you'd very much be tied to the FTSE 100 and not that much better off.
FTSE 250 Index vs FTSE SmallCap Index
If smaller companies are more nimble and innovative then you might assume that the additional risk of those investments would be worth the returns. In a similar manner to how the FTSE 250 has more risk than the FTSE 100, but offers much greater returns over the long run.
So how does the FTSE SmallCap compare with the FTSE 250?
Here's the chart:
While both of these indexes outperform the much larger FTSE 100 it would appear that from at least May 2006 the FTSE 250 has consistently outperformed its smaller counterpart.
Another thing to note is that the shapes and trends of both charts are almost identical, meaning they are both affected in the same way according to how the UK economy is performing.
Since the companies in the FTSE 250 are larger and less risky by comparison, plus with no noticeable advantages in terms of returns or behaviour seen in the FTSE SmallCap chart, it would appear that simply investing your money into the FTSE 250 is the best course of action.
FTSE 250 Index vs S&P 500 Index
With the FTSE 250 being established as the best performing index representing the UK let's compare it to the most popular index (probably) for financial independence enthusiasts, the S&P 500 index representing the general US economy.
Unfortunately the LSE website which I'm using for my graphs doesn't directly have S&P 500 data, but it does have data for VUSA - Vanguard's GBP denominated ETF that tracks the S&P 500 - and also CSPX - Blackrock's USD denominated iShares fund that also tracks the S&P 500.
Here's how they compare:
On this shortened time frame in comparison to the other charts it looks pretty clear that the S&P 500 has emerged as the clear winner despite things being almost neck and neck up until 2016, which might lead you to assume that the US market is your best option.
However, the seemingly large difference seen in the above chart only represents recent history. If you go back to 12th October 1992 and take the returns from there you'll get a somewhat different picture.
The price of the S&P 500 was 411.73 back then and closed at 4,019.87 on the 1st April 2021. This represents a total return of 876% which is an average annual return of 8.329%, better than the 7.891% we established earlier for the FTSE 250.
But not by much!
Considering the size of the UK economy ($2.83 trillion) compared to the US economy ($21.43 trillion) based on GDP data from the World Bank website, that's honestly quite impressive.
Would my money have been better off in the S&P 500 instead?
Many people out there understand the arguments for investing their money into a diversified index, and it doesn't take long to grasp the basics for those who don't. But not all indexes are equal.
The S&P 500 index tracking the broad US market for example has been a much better place to invest your money into another index, such as the Nikkei 225 - the tracker of the world's third largest economy, Japan.
And even compared to the FTSE 250 it slightly edges ahead as mentioned earlier.
So you might ask if your money would have simply been better being solely in the S&P 500 index - thereby concentrating all of your investment interests into the US.
Well, historically speaking you wouldn't have done badly - and in all honesty you'd probably continue to do quite well at least for the near to medium term.
But you can never really know.
So as an investor it makes sense to try to have even further diversification into other regions simply based on the assumption that while one country may experience a period of stagnation or poor economic performance, the others may not.
And with that as the premise, while your money would have been better off in the S&P 500 compared to the FTSE 250, especially in recent history, the bigger picture and the longer history shows that you wouldn't have missed out on all that much.
So you're getting more geographical diversification - leading to more stability and consistency in your portfolio - while only giving up a very small amount in returns.
With a weighted approach based on the size of each country's economy - similar to MSCI's ACWI Index - you could therefore maximise the benefits of this while keeping the downsides to a minimum.
Why are the LifeStrategy Funds overweight on the UK?
Vanguard UK offers a range of diversified low-cost options for people living in the UK, known as their LifeStrategy funds, where the asset allocation is balanced based on risk appetite.
Author's note: Not to be confused with the Vanguard US's counterparts such as VASGX.
You can pick from funds that have a 20%, 40%, 60%, 80% or 100% allocation to equities (stocks) with the remaining percentage being allocated to bonds.
All of these funds invest in equities around the world to give a broad coverage of the global economy, but are overweight on the UK market compared to the more traditional global trackers such as the MSCI ACWI Index.
For example the Vanguard LifeStrategy funds may have around 25% of their equities portion in the UK market while the MSCI ACWI Index only has about 4%.
The reason for this is so that investors from the UK can have a higher "home allocation" which is intended to keep a person's wealth aligned to the place where they expect to live or retire in the future. It gives additional protection against currency fluctuations and home market divergence from the rest of the world.
Imagine - as unlikely as it might seem - that the US economy came to a screeching halt while the UK economy continued as normal. This would be considered a divergence which is positive towards the UK.
With a portfolio that's more aligned to the MSCI ACWI Index you would be heavily invested into the US market and therefore impacted quite heavily by this period of bad performance. At the same time only a small portion of your portfolio would be benefitting from the UK's continued growth and progress.
That could cause problems for your financial independence as your UK holdings might not be capable of keeping you afloat - if you're living in the UK that is.
However if your home allocation was higher, like in the LifeStrategy fund, there's a higher chance that you could weather this period of poor US performance.
You'd still be affected in some manner since the US is still going to make be a large part of your portfolio, but the UK portion being larger means you're in a much better position to keep living your life as normal.
You could argue that an over-exposure to the UK would have similar risks where the UK economy suffered instead of the US economy - leading to a divergence that is negative towards the UK - but in such a case your US holdings would have you covered.
Of course, if the entire world economy suffers then you're faced with a different problem - but in such a scenario the over-allocation towards the UK market probably isn't the cause of it.
Honestly before writing this article I had no idea that the long term performance of the FTSE 250 was actually comparable to the S&P 500. It really came as a surprise to me.
I suspect I was like many others out there who simply looked at the FTSE 100 and assumed - incorrectly - that the UK had seriously lagged behind the US over the past couple of decades and that my money would simply have been better off being concentrated into the US markets.
Now, after looking a bit deeper into the FTSE indexes I have a slightly different opinion and do feel that there is a place for them in my own portfolio and anyone else's
However, if there was one thing I'd change about the LifeStrategy funds it is that there would be more priority given to the FTSE 250 instead of the FTSE 100. I feel that the FTSE All Share already sufficiently covers the FTSE 100, so there's no need to add the FTSE 100 UCITS ETF on top of it.
A better balance - in my opinion - would be to have less of the fund focused on the FTSE All Share, remove the FTSE 100 UCITS ETF entirely, and make up the difference by increasing the allocation towards the FTSE 250 UCITS ETF.
Hey - just one final word before wrapping up - The Covid-19 pandemic has brought out the best in some people while in others it has brought out the worst. Being British born Chinese it's very difficult to ignore the seemingly rising tension and unprovoked attacks against fellow Asians around the world. At the same time, I'm reminded that there have been many others who've shown incredible kindness and support.
I read a blog post by Lady Janey on How to be better post-pandemic customers in 2021. While the post isn't focused on racial issues it still highlights how everyone out there can do just a few simple things, that cost nothing, to make the world a more pleasant place for your fellow humans.