2020 Review (pt1) – Benchmarks

Contents

Coming soon:

  • Part 3 – BOKU, GAW, SOM, THRU, UCG
  • Part 4 – TBD

Benchmarks

Before I discuss my investment performance this year I think it is worth talking about benchmarks. I appreciate this isn’t the most interesting topic in the world, but it was something I needed to review and, especially since there were a couple of surprises along the way, I thought it was worth writing up.

FTSE All Share / FTSE 100

The most obvious benchmark for UK based investors is probably the FTSE All Share index.

This index is dominated by the FTSE 100 which currently comprises over 72% of its market capitalisation with the remaining 28% significantly correlated to it. The FTSE 100 has been a terrible index to track, with outsize weightings in financials and energy while technology is virtually absent. This has long led to such poor performance that only the least ambitious would compare themselves to it.

However, perhaps this is changing – top 10 constituents HSBC, Shell and BP have each lost 30-50% their value during the year, significantly improving balance. And while official weighting of technology remains absurdly low, many would argue companies like London Stock Exchange, Experian and Just Eat are miscategorised.

Year201520162017201820192020 YTD5yr10yr
FTSE 100 Total Return-1.3%+19.0%+11.9%-8.8%+17.3%-14.4%+3.7%+5.2%

FTSE 250

The FTSE 250 consists of the next 250 largest fully listed shares after the FTSE 100 and has outperformed the latter for the last few years. Constituents have a greater proportion of UK earnings making it more suitable for investors specifically targeting pound sterling returns, though investment trusts make up around 13% and many of these are international. It benefits from a very low weighting in Energy, but suffers from an overweighting in financials and, again, only modest amounts in technology. While it once again outperformed the FTSE 100 in 2020, the total return was negative.

Year201520162017201820192020 YTD5yr10yr
Total Return+11.2%+6.7%+17.8%-13.3%+28.9%-10.2%+4.8%+9.1%

AIM

The next largest UK index by market capitalisation is, perhaps surprisingly, AIM. I have ignored this index in the past because I perceived it to be dominated by a small number of very large companies at one end, each mildly tainted by their decision to avoid the more rigorous corporate governance requirements of a full listing, and a long tail of garbage at the other. Yet, upon investigation I found that AIM’s top two companies made up just 8% of the total (versus 12% for the FTSE 100), and that nearly half of its market capitalisation comprises companies that would join the FTSE 250 if they moved to a full listing.

The sector weightings in AIM are much more reflective of the current and future economy than either the FTSE 100 or the FTSE 250, for example with 11.5% in Technology and only 7% in Energy despite the notorious numbers of poor quality explorers.

I have also been surprised by the performance of AIM – up around 15% this year on top of similar gains in 2019. Earlier performance was mixed, but going forwards the AIM All Share is by no means the basket case I imagined it to be.

Year201520162017201820192020 YTD8yr
Total Return+6.6%+16.1%+26.0%-17.1%+13.3%+15.2%+6.9%

FTSE Small Cap

The FTSE Small Cap index consists of companies capitalised at between around £100m and £600m that are fully listed rather than on AIM. Over 30% are investment trusts or similar, although these have actually outperformed the rest of the index over time.

Once more the technology weighting is low, in this case probably because many new companies would prefer to list on AIM instead. The financials weighting is disproportionate to the real world economy even when investment trust are excluded. Performance has been reasonable.

Year201520162017201820192020 YTD5yr
Total Return+9.2%+14.3%+18.2%-9.5%+18.8%+0.7%+8.2%
Ex. Investment Trusts+13.0%+12.5%+15.6%-13.8%+17.7%-4.7%+5.1%

FTSE Fledgling

The FTSE Fledgling index is not useful. Nearly 40% of its market capitalisation is made up of closed-end investment vehicles and much of the remainder should have made the switch to AIM but either have greater immediate concerns (such as Mothercare) or are too conservative to do so. Constituents are very atypical of the general market or wider economy.

International

I am a UK-based investor specialising in deep research and bottom up stock selection. I am familiar with UK markets and regulation and am well placed to research most UK-based companies on the ground and meet management in person. There are around 2000 UK quoted companies of all sizes and in all sectors, many with significant foreign earnings. Accordingly I have limited need to consider overseas companies. Nonetheless, the UK is a small proportion of world equity universe and it would be foolish ignore other markets entirely.

The MCSI World index is based on the “MCSI Global Investable Indexes” methodology, which excludes growth countries such as China. It is dominated by the US at two thirds of the total, with Japan second and the UK third. For reference, it is capitalised at around $50trn versus $3trn for China and under $1trn for India.

The US and therefore MCSI World index has outperformed most other indicies, the latter returning 10% compounded over both 5 and 10 years.

Inflation / Cash / None

Ultimately what matters to most investors is absolute returns – beating an index should be little comfort if you are down 30% in the year. Furthermore, measuring performance against a benchmark can easily shift behaviour towards tracking the benchmark, or at least towards a top-down investment style that does not best exploit the advantages that a private investor has over institutions.

A fine-tuned version of this approach might be to take inflation into account – after all, a 2% return is effectively negative if inflation was 3%. Additionally, if the returns of cash in the bank cannot be beaten then the risk / reward is poor. But while inflation and interest rates are remain low this adds little value.

Unchanged Portfolio

Many investors make large numbers of trades through the year expending considerable amounts of time and money in the process. This typically also requires being up early in the mornings to catch news announcements and working at other inconvenient moments e.g. when away on holiday. If the annual returns are not higher than a portfolio left alone throughout the year then trading has not added value and the time would have been better spent relaxing or researching.

Of course, few portfolios that left alone indefinitely will outperform, and it is generally not possible to switch all of your holdings around in one go e.g. once a year, but in my view all investors should be carefully considering their performance versus an unchanged portfolio.

Adjusting for Luck

When running fairly concentrated portfolios where one share can make up 10% or more of the total it is possible for a large proportion of returns to come from a single company. While presumably this company was given a large weighting due its potential returns, it would not be unusual to get lucky with a single company.

While detailed notes on the reasons for buying and selling are the best way of distinguishing between luck and skill for individual investments, at the portfolio level excluding the biggest winner can be a useful exercise. On the other hand, not only would it be imprudent to exclude the biggest loser to compensate for “bad luck”, the portfolio loss should be limited whereas the gain from a lucky break is unlimited.

Conclusion

A fund manager with billions under management and a UK mandate cannot avoid investing in several top 100 UK companies and so the FTSE All Share / FTSE 100 is certainly a valid benchmark. Most other UK professional investors will be judged by it whether they cite it as a benchmark or not. My view has long been that most private investors should prefer the FTSE 250, but through writing this piece I discovered that the FTSE 100 has considerably improved and is perhaps now better balanced than the FTSE 250 and is unlikely to be such a soft comparator in future.

Likewise my view has changed on the AIM All Share which has clearly matured very significantly since the wild west of 4-5 years ago. The last major issue was perhaps Patisserie Vallerie two years ago, quality has shot up and it is probably the best balanced UK equity index.

For 2019 I cited absolute return, absolute return excluding my biggest winner, and return relative to an unchanged portfolio. For 2020 and in future I think it is appropriate to also compare performance to the AIM All Share. For larger investors that struggle with the liquidity of in AIM the FTSE 100 or All Share are more reasonable choices than they have been for many years.

Sources

Note: YTD figures to 30th November.

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