Some widely owned index funds can result in skewed exposure to underlying stocks © Saengdao Srisupha/Dreamstime

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Despite many seeing them as the ideal hunting ground for stockpickers, falling markets have done little to dent UK appetite for passive funds in the past year. Trackers took in nearly £10bn in net retail sales in 2022, meaning they now represent some 21 per cent of the industry assets monitored by the Investment Association.

This popularity, built during the previous decade, is understandable when you consider the good returns passives have delivered for much of that time. They also tend to offer a decent level of diversification in many cases. Having said that, some of the most widely owned trackers offer skewed exposure to their underlying markets, given their particular focus on the winning names and the fact that certain segments are left sorely under-represented. So filling some of these gaps with other funds, both active and passive, can help add an edge to your portfolio.

Popular as MSCI World trackers are, it is fair to accuse them of in effect being a play on the US, which made up 68 per cent of the index at the end of March. The S&P 500 and the global benchmark, in turn, serve as a play on Big Tech. Apple made up 4.9 per cent of the MSCI World index at the end of March, with Microsoft on 3.8 per cent, Alphabet on 2.4 per cent, Amazon  on 1.8 per cent and Meta Platforms on 0.9 per cent. That presence rises even further in an S&P 500 tracker, with Apple alone making up 7.1 per cent of the Vanguard S&P 500 Ucits ETF (VUSA) at the end of March.

That reminds us of the need for diversification in two different respects. First, it can make sense to simply bulk up on other exposure to regions outside of the US, be that Asia, the emerging markets, Japan, Europe or the UK. Trackers are one simple way to do this, and names we outlined in last year’s Top 50 ETFs list include the iShares Core MSCI Emerging Markets IMI UCITS ETF (EMIM), the Vanguard FTSE Developed Europe ex UK UCITS ETF (VERX) and the iShares Core MSCI Japan IMI UCITS ETF (SJPA).

This article was previously published by Investors Chronicle, a title owned by the FT Group.

In terms of US allocations, investors might want diversification beyond the tech majors and more exposure to the “real” economy. Premier Miton US Opportunities takes a bottom-up stockpicking approach and hunts further down the market cap spectrum. The fund has returned roughly the same as the S&P 500 over a five-year stretch, albeit with some notable differences in performance at times, including in 2022 when the fund was down 4.4 per cent versus a 9.3 per cent fall in the S&P 500.

Another way to diversify exposures on both the global front and in the US can be via income funds, which will look past most of the US tech majors with the exception of Microsoft. In the US, JPM US Equity Income  lists names such as ExxonMobil among its top holdings and has a modest allocation to the information technology sector, with financials and healthcare as its biggest sector weightings.

As previously discussed, active global funds with less of a US focus do exist. Some examples include value portfolios such as Jupiter Global Value Equity and Schroder Global Recovery, while income funds such as Murray International also look past the US. Big generalist global investment trusts such as Alliance Trust have also tended to focus less closely on the US and the tech majors.

Some passives similarly have less of a US tilt, including the relatively UK-focused Vanguard LifeStrategy multi-asset range. But with any of these approaches, investors need to ask what bias they prefer and whether they want such a heavy focus on domestic shares.

UK trackers have not always served investors well, but recently some of that underperformance has been removed. The FTSE 100 has performed well this year, with exposure to the likes of energy and some popular dividend payers working out well.

A problem here is that investors using FTSE 100 trackers miss out on exposure to small and mid-cap stocks, which have come under pressure in the past year but have fared relatively well over a longer period. As we recently discussed, names such as BlackRock Throgmorton could serve as a good play on small and mid-caps. Small-cap funds certainly look cheap at the minute following a fierce sell-off, even if they could face further problems as a recession looms.

Active UK equity funds broadly tend to have a decent focus on small and mid-cap shares, especially in the growth space. Even some of the largest and most successful names try to look beyond large caps: Liontrust Special Situations, for one, had a 43.4 per cent allocation to the FTSE 100 at the end of March, but has diversified across the market cap spectrum with 30.4 per cent in FTSE 250 stocks and 21.2 per cent in Aim. Man GLG Undervalued Assets, a popular name with more of a value bias, had a 40.8 per cent allocation to the FTSE 250 at the end of March.

The Asian market, like the US, is dominated by a few superstar names, with stocks such as TSMC and Chinese internet majors such as Tencent featuring prominently in both the MSCI AC Asia ex Japan index and MSCI Emerging Markets. That bias can be offset in different ways: funds such as Pacific Assets go a different way, namely by having a much more limited exposure to China. That, however, does leave them with big exposures elsewhere: Pacific Assets had 41.3 per cent of its portfolio in India at the end of March.

Europe has fewer such problems with Nestlé, the biggest name in the MSCI Europe ex UK index, making up 4.3 per cent of the index at the end of March. Some sector skews are still evident, but they are far from extreme: industrials, healthcare and financials each made up about 16 per cent of the index. And the average fund in the IA Europe ex UK sector tends to stay in line with some of these biases, with 17.3 per cent in industrials at the end of March according to FE data.

*Investors Chronicle offers an expert and independent view of the UK investment market. To find out more, visit investorschronicle.co.uk


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