Want to profit from the UK recovery? Don’t touch the FTSE 100

There's been a lot of political debate over whether or not US pharma giant Pfizer should be allowed to take out the UK's AstraZeneca.

On the one hand, you have people who argue that shareholders should be allowed to decide for themselves, and the government has no role.

Others argue that we should act to protect our research and development base, particularly if we want to be less dependent on financial services.

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

The extent to which you care probably depends on whether you own shares in Astra or not (and whether or not you work for them).

But there's another important angle for investors particularly those looking for exposure to the UK that you might not have noticed. If the deal goes ahead, it will expose a very significant flaw in the FTSE 100 index and the funds that track it.

Here's what it is and what to do about it.

Britain's benchmark index makes less than half of its money from the UK

Since its launch in 1984, the FTSE 100 has been the main benchmark for the UK stock market. In other words, it's the number that's quoted on the news every night it's the most popular barometer of British share performance.

So you might naturally assume that it's made up solely of blue-chip British companies, and that it reflects all parts of the UK economy. Or that it at least offers a half-decent approximation.

But in fact, it is just the hundred largest companies listed on the London Stock Exchange by market capitalisation, irrespective of nationality or any other factor.

As a result, there any many companies which aren't British in any real sense of the word. Obvious examples include firms such as South African brewer SABMiller, and Asian bank Standard Chartered.

But even those with a large UK presence make most of their money abroad. For instance, HSBC (the second-largest firm by market cap) is a well-known name on the high street. However, it employs people in 85 countries around the world and its operations throughout Europe, never mind the UK, account for just 8% of profits.

While other firms are more UK-orientated, less than a third of the FTSE 100's overall profits are generated in Britain.

Another big flaw is that the FTSE 100 is skewed heavily toward energy and mining firms, which account for over a quarter of the index by market cap. The six oil and gas firms alone represent 17.5%.

Meanwhile, banks, insurance companies and other financial services firms account for around a fifth of the index. So together they account for around 45% of shares. Throw in the energy-related utilities and the figure is closer to 50%.

However, while financial services are important to London, they provide less than 4% of jobs UK-wide, and they certainly don't account for anything like a fifth of GDP. The energy sector is even smaller, making a direct contribution to the UK economy of only £24bn in 2012. That might sound impressive, but it's only around 2% of the UK's GDP of £1.4trn.

Why the Astra deal could make the FTSE 100 even more skewed

The thing is, if the AstraZeneca deal goes ahead, this skew will get even worse. As Helal Miah at the Share Centre notes, drug companies are one of the few significant non-financial, non-energy sectors. Astra alone makes up 3.9% of the FTSE 100's total pre-tax profits.

You might not think that this matters. You could argue that it makes the FTSE 100 more attractive in some ways, as it's an easy way for investors to get exposure to the global economy, using firms domiciled in a legally stable jurisdiction.

Similarly, if you think that mining firms are undervalued (and we do) it might not be a bad thing to have a large number of them in your portfolio although we'd argue that a mining-focused investment trust is still a better way to do it.

This is all fine but only if you understand that the index which most people view as the UK's benchmark is in fact largely a tracker fund for global banks and resources stocks, with some other industries chucked in on the side. At best, the FTSE 100 might work well as a cheap global income tracker, as the yield is pretty decent but even then it's worth bearing in mind the skew towards certain sectors.

If you're looking instead to invest in stocks that have exposure to the UK economy, the FTSE 100 isn't for you. In fact, often things that are good for the UK economy are bad for FTSE 100 stocks, and vice versa.

For example, take energy prices. Rising prices are bad for the UK overall they push up costs for firms and squeeze the consumer, hitting retail spending. But they clearly benefit firms drilling for and refining oil and gas.

Meanwhile, the recent Budget decision to allow people much more freedom over what to do with their pension pots could boost overall UK growth. But it was also bad news for financial companies, who saw their profits on annuities reduced.

What to do if you want exposure to the UK economy

There are several ways to get around this. The first is to buy a broader index that covers more companies. A popular alternative is the FTSE All-Share Index. This one is actually older than the FTSE 100, having launched in 1962. It covers more than 600 companies most of the overall market in terms of market cap.

But because it still includes the top 100 companies, it's still very skewed towards oil and gas, and basic resources. And the importance of financial services is actually greater, so there really isn't much difference.

A better option is the FTSE 250. This contains the next 250 companies down from the top 100, so it genuinely gives you exposure to a different set of companies, many of them far more tightly tied to Britain's economic fortunes manufacturers, exporters and housebuilders, for example.

Or you could go for the MSCI Small Cap index, which contains 243 smaller firms. While it still includes a high proportion of financials, materials and energy accounts for only 15%. The largest shares held include firms such as housebuilder Taylor Wimpey and packaging company DS Smith. One exchange-traded fund (ETF) that tracks it is the iShares MSCI UK Small Cap UCITS ETF (LSE: CUKS).

Alternatively, you could go for a UK small-cap investment trust. These have done well in recent years, but with nearly a year to go until the next election, politicians and our central bank are likely to keep ramping things up. Bank of England boss Mark Carney already seems to have bottled it on raising interest rates any time before next May, which could keep the party going.

Regular MoneyWeek contributor David C Stevenson ran through some of his favourite small-cap trusts recently.If you're not already a subscriber, right now you can get your first four issues free and get access to our entire web archive see here for more.And you can find out more about investing in small-caps on our penny shares page.

Our recommended articles for today

The 14 stocks our experts are buying into now

SUBSCRIBERS ONLY

Where next for the euro crisis? For Russia? For Japan? For UK house prices? John Stepek talks to our panel of experts to find out what they're buying.

Five reasons the FTSE could break its record

The FTSE 100 index is within touching distance of its all-time record high. Bengt Saelensminde outlines five reasons why it could soon break through it.