Are your tracker funds going where you think they are?

Always pay attention to what's in your tracker fund. For example, the FTSE 100 sounds like a benchmark of UK companies and, therefore, of the British economy. But it isn't. Of its earnings, 70% are now estimated to come from abroad. And that trend is accelerating.

There's been a recent flood of foreign companies seeking to list on London's stock exchange. To encourage large corporations to relocate here, British regulators have waived the usual requirement that a quarter of a listed firm's shares must be freely tradeable (ie, not tied up by large controlling shareholders). FTSE, the UK-based index compiler and publisher of Britain's most popular share indices, has been willing to admit large companies with as little as 5% free float' (industry jargon for freely tradeable shares) to its benchmark indices.

Unsurprisingly, many of the foreign companies seeking to list in London have made little secret of the fact that gaining index inclusion is a key motivating factor. Why? Because billions of pounds of investors' cash tracks indices in the form of index funds and exchange-traded funds (ETFs), so getting access to this pot of money can boost demand for their shares.

Subscribe to MoneyWeek

Subscribe to MoneyWeek today and get your first six magazine issues absolutely FREE

Get 6 issues free

Sign up to Money Morning

Don't miss the latest investment and personal finances news, market analysis, plus money-saving tips with our free twice-daily newsletter

Don't miss the latest investment and personal finances news, market analysis, plus money-saving tips with our free twice-daily newsletter

Sign up

There's nothing wrong in this as such companies will naturally seek out capital. But when new arrivals pay lip service to Britain's corporate governance rules (as has apparently been the case with Kazakh mining company ENRC) and the rules are written with a great deal of leeway, index-following investors should watch out.

So how can you avoid filling your portfolio with unwanted firms? First, understand how the index you're tracking selects its components and what's actually in it, and how sector exposure has varied over time. Second, consider investing in industry sectors via index funds and ETFs, rather than in the benchmark country' indices you see reported in the evening news. Finally, be aware that the more popular an index is with tracker funds, the greater the scope for index-related distortions (because there's more money chasing them). Less popular indices cost more to invest in, but they may be a much safer bet.

Paul Amery edits www.indexuniverse.eu , the top source of news and analyses on Europe's ETF and index-fund market.