Unless you’ve been hibernating for the last twelve months, you’re probably aware that ‘smart beta’ is the hottest topic in the ETF world right now. Everyone talks about it and seems to have a strong opinion about it. Some will try to convince you that by weighting a traditional market capitalisation index differently they’ve built a better mousetrap, while others will argue there is nothing new under the sun.
Where everybody seems to agree, though, is that the marketing term ‘smart beta’, is rather inappropriate, if not outright misleading. Why? Because it implies that traditional indices – those that are not ‘smart’ – are dumb. The reality is of course much more complex than that.
That said, it must be recognised that some traditional indices tracked by index funds and ETFs may indeed be somewhat dumb. And in this article, I’d like to highlight one in particular, the FTSE 250.
The FTSE 250 is a well-known and widely-followed index made up of the 250 UK stocks ranked below the FTSE 100 Index measured by full market capitalisation. With a 73% allocation to mid-caps and 20% of small-caps, it is often cited as a proxy for the UK midcap market. However, investors should be mindful of the real composition of the FTSE 250. It is not a pure mid-and small-cap play.
Almost 15% of its holdings consist of UK investment trusts – a mixed bag of assets, strategies and geographic exposures that have little or no connection to the UK mid-and small-cap market. In fact, the majority of the 43 investment trusts included in the FTSE 250 index invest in global equities and sectors. The three largest are private equity group 3i (III), allocation fund Alliance Trust (ATST) and global equity fund Scottish Mortgage (SMT).
You might wonder why investment trusts are included in the FTSE 250 in the first place. The answer has to do with their legal structure. Investment trusts are closed-end funds constituted as public limited companies and organised as such. Hence, they qualify for the family of FTSE indices. By contrast, ETFs, which also trade on exchange, are not eligible for inclusion in FTSE indices. And this, for the simple reason that they are open-ended funds. So for instance, you will never see a FTSE 100 ETF or a FTSE 250 ETF in the FTSE 250 index; and just as well.
To find out how investment trusts affect the performance of the FTSE 250 index, let’s compare it to the FTSE 250 ex-investment trusts index. Over the last three years, the FTSE 250 has underperformed the FTSE 250 ex-Investment Trusts by 6.20% on a cumulative basis or 1.56% on an annualised basis.
In the long run, the compounding effect can make a big difference. Over the last 10 years, the FTSE 250 has lagged the FTSE 250 ex-Investment Trusts by 19% on a cumulative basis, or shy of 0.70% on an annualised basis.
This strongly suggests that investment trusts in the FTSE 250 tend to act as a drag on the index’s performance over time; and this would be most evident in market environments favourable to UK medium-sized companies as seen in the last three years on the back of an improving UK economy.
Obviously this is not to say that investment trusts are bad investments. There are, of course, good ones. For instance, Scottish Mortgage, Murray International (MYI) and City of London (CTY) all carry a Gold Morningstar analyst rating, while 16 others are rated either Silver or Bronze.
However, investing in all UK’s biggest investment trusts without discriminating, like any fund tracking the FTSE 250 does, is not a good idea in principle. As mentioned, investment trusts form a heterogeneous group of strategies with extremely different dynamics at work.
Right now, there are four ETFs tracking the FTSE 250 index. The largest one is the iShares FTSE 250 (MIDD) with more than £1 billion in assets, followed by the HSBC FTSE 250 ETF (HMCX), Source FTSE 250 ETF (S250) and Lyxor FTSE 250 ETF (L250). On the conventional index funds side, both BlackRock and HSBC offer a FTSE 250 tracker.
At a time when everyone is trying to be smart, it is surprising that no one has yet considered offering an index fund or an ETF linked to the FTSE 250 ex-Investment Trusts instead of the FTSE 250. And yet, that could be a smart move.
