The best way to invest in Britain’s stockmarket

published 2 November 2012

What's the best way to invest in our stockmarket?

Giving your money to a professional fund manager is one option, but often a bad idea. Most of them charge you a lot of money for not a lot of performance.

Plenty of investors have already woken up to this fact and prefer to put their money into cheap index-tracking funds instead. But this is when you hit another problem which one to pick?

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It's all too easy to think you'll get a decent exposure to the British stockmarket by buying a simple FTSE 100 tracker. But I think this is a mistake. Here's why and what you should buy instead.

The FTSE 100 isn't what you think

Most of us are familiar with the FTSE 100 - an index of the biggest100 UK-listed companies measured by their market value. How it has performed during the day is mentioned on the news every evening and talked about in the next day's newspapers. But is it a good investment?

You'd think that buying a fund that puts your money in about100 different companies (the quarterly reshuffle can leave it with slightly fewer than 100) would be a good thing to do. After all, not putting all your eggs in one basket is supposed to reduce your investment risk, right? But I'm not sure it does in this case.

You see the FTSE 100 is dominated by a few big companies and industry sectors. By buying a FTSE 100 tracker fund, you are getting a pretty skewed exposure.

If you have a look at how the FTSE 100 is made up you'll see what I mean. For example, six stocks - Royal Dutch Shell, HSBC, Vodafone, BP, Glaxo and British American Tobacco - account for 37% of the value of the FTSE 100. The ten largest stocks make up nearly half its value.

Personally, I've got nothing against concentrated stock portfolios (ones with large positions in a small number of stocks). They can allow you to make a lot of money. But if I'm going to run one, I'm going to select companies because they are good quality and can grow a lot, not just because they are big.

If you think about this a bit further, why should very big companies be good investments? The law of large numbers tells us that it's very difficult for things that are already big to become proportionately much bigger.

For example, it's a lot easier for a company with a value of £10m to increase in value by 50% than it is for a company with a market value of £10bn to do the same.

Now have a look at the industries your money is invested in via the FTSE 100. 31% is in energyand mining, 18% in financial companies and 8% is in pharmaceuticals - not far off 60% in just three areas. This hardly looks diversified and low risk to me. I'm not sure about the growth prospects either.

And yet the majority of the fund management industry benchmarks itself against indices like this that are heavily invested in just a few sectors (note the FTSE All-Share index is dominated by the FTSE 100 companies with around 45% of its value in the three areas above).

The dominance of big companies and big sectors may explain why the FTSE 100 may struggle to go up much in the years ahead. Luckily there's a good alternative to buying the FTSE 100.

Why you should buy a FTSE 250 tracker instead

If you are going to buy a UK index tracker fund, you might be better off buying one that tracks the FTSE 250 index - the 250 next biggest companies outside the FTSE 100.

Over the last decade, it has been consistently a much better home for your money, as it contains lots of smaller companies that find it easier to grow.

Total returns with dividends reinvested

Swipe to scroll horizontally

FTSE 100	10.3%	28.3%	5.5%	112%
FTSE 250	18.5%	44.7%	18.3%	262%

Source: Bloomberg

It's also a much more diversified and less risky investment than the FTSE 100. Not only does it contain more companies but it is much more evenly spread across companies and industries. For example, builders merchant Travis Perkins (LSE: TPK) is the biggest company in the index but its market value only accounts for 1.16% of it.

As for what to buy, the HSBC FTSE 250 Index offers a cheap way to invest with a total expense ratio of just 0.29%. When buying these funds watch out for hidden platform costs though (costs that can be charged by some fund supermarkets or fund wrappers for holding these funds). Sometimes it can be cheaper to buy direct from the providers (the HSBC investor services line is 0845 745 6123).

This article is taken from the free investment email Money Morning. Sign up to Money Morning here .

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Phil spent 13 years as an investment analyst for both stockbroking and fund management companies.

After graduating with a MSc in International Banking, Economics & Finance from Liverpool Business School in 1996, Phil went to work for BWD Rensburg, a Liverpool based investment manager. In 2001, he joined ABN AMRO as a transport analyst. After a brief spell as a food retail analyst, he spent five years with ABN's very successful UK Smaller Companies team where he covered engineering, transport and support services stocks.

In 2007, Phil joined Halbis Capital Management as a European equities analyst. He began writing for MoneyWeek in 2010.