The FTSE 100 is one of the first things that comes to mind when you think of ‘the UK market’, hosting the biggest names in the country – but it is also one of the biggest problems for UK investors, according to Andrew Vaughan, manager of the SDL Free Spirit fund.
According to Vaughan, one of the issues is that the FTSE 100 “completely dominates” the FTSE All Share index, meaning just a handful of mega-cap names end up distorting the entire market.
This leads onto the second bigger issue, which is that the majority of FTSE 100 stocks are value and cyclical companies such as banks, basic resources and financial services. These three sectors are among the top five biggest weightings in the index.
Performance of FTSE 100 vs global equities over 3yrs
Source: FE Analytics
These types of companies are currently enjoying a rally due to the post-Covid ‘reopening trade’, but Vaughan believe they are not the areas which will deliver outperformance for investors over the long term.
“These are actually businesses that are on the wrong side of some very big trends that are happening in the world,” he said.
“We're moving to clean energy [and] it's very hard to see the future of someone like Shell or BP. FinTech is coming along and negative interest rates [are] coming along – these are existential threats for banks. 
“Our two largest sectors are not quality and not growth. It doesn't matter what level you price them even if you say they're looking cheap, these are not businesses and not sectors that have rosy futures ahead of them.”
Effectively, if investors follow the make-up of the FTSE 100 index they will not be holding the companies and themes which the SDL Free Spirit manager expects to perform well long term.
It’s worth noting that the five FE fundinfo Crown-rated SDL Free Spirit fund does hold some large-cap and value names, but Vaughan (pictured) and his colleague FE fundinfo Alpha Manager Keith Ashworth-Lord predominantly focus on growth small and mid-cap companies.
Vaughan added that this dislike of the FSTE 100 doesn’t make him negative about the UK market as a whole. “It just happens to have a disproportionate representation in the stock market,” he explained.
Continuing with the example of UK banks, Vaughan said that fundamentally they’re all about the risks that come with lending, which makes it hard to discern where their profits are coming from.
“The bottom line though is that the banks don't produce adequate returns on capital. And that is an inescapable fact,” he said.
“And so even though their price may become very, very cheap, that doesn't mean that they suddenly become great businesses. I mean, they really haven't.
“Those bank stocks that have been performing very well, I mean you could absolutely have made 50 per cent in HSBC, for example. But before it rallied HSBC was at a 20-year low, so you'd have spent 20 years on a downturn.
“These are just not fundamentally good businesses nor do they produce good returns on capital. If you get into the value game, by definition you can't be a long-term holder because there's a point at which you have to sell because cheapness is the only positive attributes of these companies.”
Taking such a strong stance on growth has meant that his SDL Free Spirit fund - like most growth funds - has seen a decline in its near-term performance because it’s not overly exposed to the rallying parts of the market, something which Vaughan acknowledged.
“It does affect our performance relative to the near term [and] to what other funds are doing and relative to the All Share index,” Vaughan said.
“[But] the answer is we're not going to change our investment process. We're absolutely wedded to this idea of quality and growth.”
SDL Free Spirit made top quartile returns in 2018, 2019 and 2020 before slipping slighting 2021. This track record means it has made the seventh highest return of the IA UK All Companies sector over the past three years, despite a more challenging time in recent months.
Performance of fund vs benchmark over 3yrs
Source: FE Analytics
Vaughan continued: “Generally our view is that, first of all if you look back at whenever markets have recovered from a sell-off […] normally coming out of those situations it’s the value stocks that lead the recovery and then over time, people come back to quality.
“And the reasons for that is that people, obviously, are drawn to things that look cheap. But then they become disappointed with the operational performance. And they're just not seeing the growth in the performance of the businesses coming through.”
SDL Free Spirit has an ongoing charges figure (OCF) of 1.16 per cent.