When people talk about investing in UK stocks, they are often referring to the well-known leading companies that make up the FSE 100.
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this index is also used as a proxy for the uk stock markets as a whole; So we had reports of the ftse 100 crashing from 7,500 to 5,000 at the start of the covid-19 pandemic as an illustration of how the entire market was doing. going through the crisis.
Reading: How to invest in the stock market uk
But there is a wealth of choice beyond the UK’s flagship index, with the potential for outperformance from smaller companies compared to their larger counterparts.
In fact, investors in the fledgling ftse index would have enjoyed a total return of almost 40% over the past five years, well above the 19% return of the ftse 100.
Let’s take a look at the different options available to investors in the main market and the alternative investment market on the London Stock Exchange, along with the investments that have generated the highest returns in recent years.
Remember that investing in the stock market is speculative and your capital is at risk. you may not get back some or even all of your money.
what markets are available on the london stock exchange?
The London Stock Exchange (LSE) is one of the oldest stock exchanges in the world and allows companies and governments to issue shares and bonds to raise money. Once issued, these stocks and bonds can be traded by institutional and private investors.
the lse has two markets: the main market and the alternative investment market (target), which are differentiated by the types of listed companies and their respective regulatory requirements.
- main market
More than 1,300 companies from 70 different countries are listed on the main market, including shell, astrazeneca, hsbc and unilever. companies must meet strict regulatory requirements before their shares can be listed on the main market.
That said, the city’s regulator, the Financial Conduct Authority (FCA), recently relaxed listing rules to attract “initial public offerings” to list on the LSE rather than on rival European exchanges.
This included a reduction in the free float (shares available to the public) from 25% to 10%, but an increase in the minimum market capitalization from £700,000 to £30 million.
The core market also includes three segments covering high-growth companies, specialized funds and premium companies (with higher listing standards).
- alternative investment market (target)
aim, also known as the “junior market”, was established in 1995 as an alternative market for small and medium-sized businesses to access financing.
More than 1,200 companies are currently listed on AIM, including vacation provider Jet2, retailers Boohoo and Hotel Chocolate, and market research provider YouGov.
why do companies choose to list on aim? mainly due to lighter regulatory requirements, which are less expensive and less time consuming than the mainstream market.
There is also no minimum “free float” or market capitalization and, unlike the mainstream market, companies are not required to have a three-year trading history.
as a result, aim tends to attract higher-growth companies at an earlier stage of development; According to Grant Thornton, AIM companies achieve an average 40% revenue growth in the first three years after their IPO.
However, the target is no longer just for smaller companies and includes several companies with a market capitalization of over £1bn. Companies like Asos and Domino’s Pizza started out with the target before moving into the mainstream market.
What should investors know about indices?
There are a variety of indices in both the core and target markets that aim to track the aggregate performance of selected groups of companies.
The indices are reviewed quarterly by ftse russell, the company that operates the indices. this provides the opportunity for companies to be “promoted” to a higher index if their market capitalization (“market capitalization”) has increased sufficiently.
However, a “promotion” threshold is set for each index to safeguard the stability of the companies listed in the indices. for example, a company must have risen to at least rank 90 to be added to the ftse 100, or fallen to rank 111 or lower to be removed.
Adding to a higher index tends to have a positive effect on a company’s share price, as funds from index trackers will be required to purchase their shares to replicate the index. however, the opposite is true for “relegated” companies that may experience a “double hit” on their share price.
These are some of the most popular indices for the major market:
- ftse 100
The Financial Times Stock Exchange (FTSE) 100 is the gold standard of LSE indices and is often used as a barometer for the wider UK stock market.
comprises the 100 largest listed companies on the major market by market capitalisation, with an average value of £20bn. AstraZeneca is currently the largest company in the FTSE 100, with a market capitalization of over £170bn, with Port Power at the other end valued at £3bn.
The ftse 100 focuses heavily on blue-chip stocks in the commodities, financials and consumer staples sectors. The FTSE 100 companies include Shell and BP in oil, Anglo American and Rio Tinto in mining, and HSBC and Barclays in banking.
Larger capitalization companies have a higher weighting in the index; for example, shell and astrazeneca each have a current weight of 8%. As a result, any change in the share price of these companies has a significant impact on the index as a whole.
the ftse 100 also has a strong international focus, with more than 75% of revenue coming from abroad, according to ftse russell. In addition, companies such as BP, Shell, HSBC and AstraZeneca report their results in dollars since most of their transactions are made in dollars instead of pounds.
- ftse 250
The FTSE 250 comprises the largest companies between 101 and 350 by market capitalisation, with a considerably lower average value of £1.4bn than the FTSE 100.
The FTSE 250 covers a broader range of industries and is more evenly weighted than the FTSE 100, with no company representing more than 1% of the total index.
In contrast to the ftse 100, only 50% of revenue is earned abroad; As a result, the FTSE 250 is a better indicator of the overall health of the UK economy due to its national focus.
Medical supplier Convatec is the largest company in the FTSE 250 at £4.5bn, with the smallest being Hochschild Mining at just under £430m.
- ftse 350
The FTSE 350 covers the 350 largest companies listed on the main market and is simply the FTSE 100 and 250 combined. The average market capitalization of the FTSE 350 companies is £6.7bn.
- small-cap ftse
ftse small cap contains the companies from the ftse all share index that are not large enough to qualify for the ftse 350. In other words, the largest companies from 351 to 600 by market capitalization.
Topping the index is real estate company home reit with a market cap of over £900m, with cookware company procook bringing up the rear with a market cap of £42m. sterling pounds.
- ftse all share
the ftse all share is the sum of the ftse 100, 250 and small cap indices. the 600 companies included in the ftse all share index represent 98% of the market capitalization in the main uk stock market indices.
- ftse newbie
the fledgling ftse index covers the 77 companies that are too small to be included in the fse all share, with the majority being investment trusts and other financial companies. the average market capitalization is £50 million, with a range of £1 million to £170 million.
There are fewer indices to point to, but the main ones are:
- ftse aim uk 50 index: top 50 companies by market capitalisation, with an average market capitalization of £590 million. The life sciences company, Abcam, is the largest in the Target 50, with a market capitalization of £2.8bn.
- ftse aim 100 index: ai’s 100 largest companies, with an average market capitalization of £495 million.
- ftse aim all-share index: covers over 760 aim companies, with an average market capitalization of nearly £100m.
Which indices have generated the highest returns?
Small-cap indices tend to outperform larger rivals in an economic boom due to their higher growth potential. Or, as investment expert Jim Slater put it, “Elephants don’t gallop.”
Smaller-cap indices also tend to be less covered by analysts, which may appeal to investors hoping to discover the next big growth story.
However, larger-cap indices tend to be more resilient in an economic downturn, partly because of their larger financial reserves, but also because of their focus on foreign markets, rather than just the UK.
Let’s take a closer look at the relative performance of the major indices over the last 5 years to see if this is the case:
Over the last five years, the FTSE Fledgling Index delivered a return of 38%, more than double the return of the FTSE 100 index and four times the return of the FTSE 250 index. The FTSE Small Cap was the second highest performing index with a five year return of 29%.
While small-cap indices outperformed large-cap indices, the ftse 100 comfortably outperformed the ftse 250 with five-year returns of 19% and 9%, respectively.
Much of this difference is due to their performance over the past year, with the ftse 100 down 1% compared to 19% for the ftse 250.
the performance of the ftse 250 is more closely tied to the uk economy, with weak gdp data weighing on the index. Similarly, the strength of the US dollar against the pound has helped FSE 100 companies make significant profits abroad.
the ftse 100 index has also been buoyed by extraordinary gains by energy companies such as shell and bp.
That said, returns are only part of the equation and should be considered alongside the risk of investing in each index…
What is the risk of investing in each index?
Investors will also want to consider the risks of investing in an index, both in terms of volatility and the risk of losing money.
- How does volatility vary by index?
One measure of risk is volatility, in other words, the extent to which stock prices rise and fall. high volatility can make it difficult for investors to time their buying and selling.
Smaller companies typically experience greater volatility in stock prices, as they have more limited financial resources to fall back on in an economic downturn. this can make its share price more vulnerable to negative investor sentiment in falling stock markets.
Susannah Streeter, Senior Investment & Markets Analyst, Hargreaves Lansdown comments: “Entering early in a company’s growth cycle has the potential to reap significant long-term rewards, but these actions also carry greater risk.”
also warns that small caps “may be subject to much greater speculation, which can lead to overvaluations.”
Looking at monthly changes in the indices over a five-year period, ftse russell reports that the largest cap ftse 100 had the lowest volatility at 14% and the fledgling ftse the highest at 19%.
However, the exception to the rule was the ftse 250, which experienced higher volatility than the small-cap ftse. One reason is the higher proportion of investment companies, such as mutual funds, in the small cap of ftse, which are actively managed to reduce volatility for shareholders.
- How does the risk of having losses vary according to the index?
While investors will want to make money in rising markets, it can be just as important to protect investments in a stock market downturn. we have compared the performance of the indices in two recent years with losses (or negative gains):
All of the indices were loss-making in 2018, with the FTSE 250 making the highest loss of 13% and the FTSE Fledgling the lowest at 7%.
however, there was a much more mixed performance in 2020. while both the ftse 100 and 250 posted losses, the small cap and fledgling ftse withstood the stock market crash to post positive returns of 7% and 11%, respectively.
Overall, even though smaller-cap indices experienced greater volatility, they managed to weather stock market downturns better than their large-cap counterparts.
how can you invest in the uk stock market?
There are two main ways to invest in the UK stock market: buy company shares directly or invest indirectly through a fund, investment trust or exchange-traded fund (ETF).
You can buy these products in a general investment account. Alternatively, you can buy them and hold them in a tax-efficient “wrapper” such as an individual savings account, a self-invested personal pension, or a junior ISA.
- buy shares of a company
You should be able to buy most stocks on the main market or target through a trading platform, such as Hargreaves Lansdown or AJ Bell. We have compiled a list of the best trading platforms to compare the different fees and features of the top providers.
However, there is a difference in the price and ease of buying larger-cap stocks. Large-cap stocks have high trading volumes, which means it’s easy to buy and sell their shares. you will also pay a low “buy-sell” spread.
by contrast, small-cap stocks are generally less liquid; in other words, they are more difficult to buy or sell quickly without having a significant impact on the stock price. this has an impact on the price and can also create a problem when you try to sell shares (if you have to lower the selling price to attract a buyer).
Let’s look at a couple of examples:
- barclays is an ftse 100 company, with a current daily trading volume of more than 28 million shares. my trading platform quotes a bid spread of 150.96 (sell) to 151.04 pence (buy), a difference of only 0.05%. In other words, if I pay 151.04 per share, I would need the share price to go up just 0.05% to “break even” if I wanted to sell my shares.
- topps tiles is a small cap ftse company, with a trading volume of around 53,000 shares per day. the bid-ask spread is currently 39.0 to 41.0 pence, a difference of almost 5%. therefore, the sale price would have to increase by 5% to match the purchase price of 41 pence per share. Due to the much smaller volume, the trading platform charges a higher “margin” on less liquid stocks.
Most, but not all, trading platforms charge a share trading fee for buying or selling shares, usually a flat fee of between £5 and £10 per trade. You will also have to pay a stamp duty of 0.5% on the value of the transaction.
You may also need to pay an annual platform fee to own shares, which is usually charged as a percentage of the value of your shares.
Investing in individual shares of a small-cap company can offer the potential for high returns, but also carries higher risk than investing in an FSE 100 company. However, investing in a collective investment product, such as a fund , should reduce the risk of an individual company underperforming.
- indirectly invest in the UK stock market
investment products such as funds, mutual companies and etfs provide a ready portfolio of uk stocks. there are two main types:
- Passive investments: Aim to track or replicate an index and, as they are not actively managed, tend to charge a lower annual fee of around 0.2%. There is a wide range of index funds that cover the FTSE 100, 250 and all stock indices, but not small-cap and nascent indices.
- active investment: charge a higher commission of around 0.4% to 1.0%, as they are actively managed by a fund manager. there is a wider selection of active investments for smaller cap funds than index funds.
Depending on the type of product, you may pay a flat transaction fee to buy and sell these products, along with a platform fee.