Pfizer’s takeover approach for UK/Swedish AstraZeneca is the subject of intense political and financial scrutiny, with much of it focusing on the consequences for the employees and shareholders of AstraZeneca. However, Miah (pictured) says that what has been less appreciated is the loss of AstraZeneca from the FTSE 100 would increase its heavy bias towards banks and commodities and make a tracker a far riskier investment.
“The loss of AstraZeneca from the FTSE 100 would hammer home the inherent dangers of index investing if the index in question is not well diversified across different sectors,” he said.
“The FTSE 100 is heavily biased towards commodities and financial services, with more than half of pre-tax profits in the last five years generated by commodities firms or banks.”
“Pharma has long been a crucial alternative, and has been the fourth largest profit generating sector since 2009.”
“Given that AstraZeneca has made nearly half of the profits in the sector, its loss will mean investors in the index will have their cash even more heavily invested in oil, mining and banks.”
The weighting of the UK market towards certain sectors is one factor that means trackers tend to outperform active funds at certain times and not at others.
Data from FE Analytics shows that active funds have been enjoying a period in the sun, with a surge in relative performance to the FTSE and to passive funds over the past two years.
Relative performance of active and passive funds to FTSE over 7yrs
Source: FE Analytics
One reason behind this is that active managers have been overweighting the FTSE 250 and even the FTSE Small Cap index in some cases, as we highlighted in an article back in December.
However, another factor was the performance of a handful of the largest stocks on the index. The FTSE 100 is very top heavy, meaning that a poor run for the miners and oil and gas sectors can hold it down.
These sectors have started to outperform relative to the index in recent months and this has pulled up the trackers and the overall index relative to active funds.
Performance of miners and oil and gas relative to FTSE in 2014
Source: FE Analytics
Miah points out that investors in an index tracker are already highly exposed to the success of just a handful of industries, far more so than in the US market for example, and the situation is getting worse.
Oil and gas, basic materials and financials account for 45 per cent of the FTSE 100 weightings in terms of market cap. By contrast, in the US S&P 500, they account for just 30 per cent
The same three sectors account for for 65 per cent of FTSE 100 revenues, 60 per cent of pre-tax profits, and 53 per cent of net profits in the last five years.
The pharmaceutical sector has made up 8.6 per cent of pre-tax profits in the FTSE 100 in the last five years, Miah says, but only 2.8 per cent of revenues.
The disparity is because of the high profit margins in the sector which allow it to pay such high dividends.
This makes it the fourth-biggest contributor to profits after oil and gas at 24.3 per cent, mining at 19.3 per cent and Banks at 9.3 per cent.
In fact, AstraZeneca itself has been in the top ten companies in terms of net profits in four of the last five years, with the exception being 2013 when profits fell by 60.7 per cent.
Performance of stock vs index over 5yrs
Source: FE Analytics
Over the last five years as a whole AstraZeneca has made up 3.9 per cent of the FTSE 100’s total pre-tax profits, and 44.9 per cent of pre-tax profits in the pharmaceutical sector.
AstraZeneca is currently the sixth largest stock on the index, and were it to be removed would substantially deplete the influence of the pharmaceutical sector on the benchmark.
It would represent a second blow to the index’ diversity in recent months following the sale of its Verizon Wireless stake by Vodafone which almost halved the latter’s market cap.
BT Group is the only company in the same sector to appear in the FTSE 100.
“It [Astra] is a valuable contributor to the diversity of a UK equity portfolio,” Miah said. “If/when AstraZeneca disappears, investors will only have GlaxoSmithKline and the much smaller Shire in the pharma sector, affording them fewer opportunities to diversify their holdings.”
The removal of AtraZeneca would also potentially leave passive investors more exposed to global financial shocks, Miah warns, thanks to the biases of the stocks that remain.
“Commodity firms and the financial industry are much more likely than many other industries to be affected by global shocks, leaving UK investors relatively exposed, so it is important that portfolios are appropriately diversified to manage the potential risks,” he said.
“Investors need to be very well aware what they are buying if they are considering an index fund.”
This is a feature of passive investing that also concerns Rob Gleeson, head of research at FE.
He says that the correlation between the major indices is increasing and is already at such a level that it makes little sense to build a portfolio based on geographical exposure and it is highly risky to put together a set of trackers for the world’s main markets.
A portfolio constructed in such a way will include a high number of multinational businesses in a handful of sectors which are highly correlated with one another and with global growth rather than the diversified profile investors intend to create.
