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Looking under the bonnet: How diversified is your tracker fund?

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Helal Miah of The Share Centre warns of the dangers for index investors of being too heavily exposed to one sector.

Index investing – or tracker funds – have traditionally been seen as a lower risk, and relatively simple way for investors to buy equities. But this is not always the case.

Diversification is a means to minimise the risk particular stocks or sectors bring to a portfolio. While an index fund may track the performance of an index with unerring accuracy, the index it is tracking may not be particularly diverse to begin with.

If the index is skewed and concentrated, investors will be exposed to more sector and stock specific risk than they are aware of.

With this in mind, it is crucial that investors understand the different moving parts of an index they are investing in to avoid facing unexpected risk.

You wouldn’t buy a car without checking under its bonnet, and the same is true of investing.

Perhaps the most pertinent example is the FTSE 100, which is heavily dependent on several huge industries.

At industry level, Oil & Gas, Basic Materials and Financials account for 45 per cent of the FTSE 100 market capitalisation. That means an investor’s money will be concentrated in these industries. By contrast, in the US, the same three industries account for just 30 per cent of the S&P 500 index.

It is not just the weighting of the FTSE 100’s market cap that shows the lack of diversity, but in its profit and loss account.

According to analysis from our latest Profit Watch UK report, companies in Oil & Gas, Basic Material and Financials account for 65 per cent of FTSE 100 revenues, 60 per cent of pre-tax profits, and more than half of net profits on the index.

But digging down even deeper, the FTSE 100 is not just dependent on the largest sectors, but the largest companies operating within those sectors. For instance, Shell and HSBC alone account for around 7 per cent of the market capitalisation of the FTSE 100.

However, they are even more crucial to the overall balance of the index, accounting for 19 per cent of revenues and nearly a quarter of net profits in 2013.

So for investors tied into the index, they could be much more exposed to poor performance of a minority of stocks than they realise when opting for a tracker fund – much more so than in a portfolio of stocks or funds actively selected for diversity.

For this reason alone, investors with tracker funds should welcome new blood coming to the market – with sizeable new issues such as Royal Mail playing a part – albeit a small one – in boosting sector diversity.

Similarly, large-scale acquisitions of listed firms can increase risk. For instance, Pharma has been a valuable contributor to the diversity of a UK equity portfolio, making up nearly 9 per cent of FTSE 100 pre-tax profits. The loss of AstraZeneca from the index, if Pfizer had been successful at its recent failed acquisition, would have nearly halved the contributions pharmaceuticals made to the FTSE 100’s profits. The index would have rested even more heavily on the performance of banking and commodities heavyweights.

Understanding exposure to risk and volatility is part and parcel of good investing, and a well-constructed portfolio should be appropriately diversified to manage potential sector specific risks.

This is not always the case with tracker funds, and investors would do well to make sure they understand the constituent parts of the FTSE 100 and their influence before they invest in the vehicle.

Helal Miah is investment research analyst at The Share Centre

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