A Scottish Tracker would be lumpy and bumpy

Friday, Nov 09 2012 by
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A Scottish Tracker would be lumpy and bumpy

The prospect of Scottish independence raises a number of issues, one of which would be the merits of a passive fund to track Scottish companies. There are many uncertainties to be resolved affecting Scottish companies such as currency, banking supervision and regulatory regime. Nonetheless, working on the premise that existing listed Scottish companies (as defined by the Scotsman’s Scottish Share Index) retain their domicile in Scotland post-independence, what would the index look like? And does it represent an attractive investment proposition and a means of gaining exposure to traditional strengths such as whisky, financial services and the energy sector?

From the outset the index, calculated using market capitalisation and valued at £64bn, would suffer from overexposure to a limited number of companies because the universe of 33 stocks is quite small. Royal Bank of Scotland (RBS) would presently represent 40% of the index weighted by market value. This is despite the fact the share price has fallen 95% or so from its peak. Adding Standard Life (9% of the index), Aberdeen Asset Management (5%) and Alliance Trust (3%) and F&C (1%) would further increase the dominance of the financial sector to almost half the index. The next biggest would be SSE, the gas and electricity utility, at 18%, followed by the engineering companies Aggreko and Weir, at 7% and 5% respectively. Replicating such an index through an OEIC would be impossible given the constraints on the maximum holdings size to limit concentration.

Given the dominance of a handful of companies in the Scottish index, a passive fund tracking the index would have given a very volatile ride. FTIM carried out some simple back-testing on the index over a 10 year period, rebalancing the index by market value at the beginning of every year. From the start of 2002 to the start of 2012 the index would have fallen 30%, dragged down by the performance of HBoS and RBS which made up over two-thirds of the index for the first 6 years. This year it would have staged a bit of a recovery as RBS has risen sharply, jumping 24% by the beginning of November.

Using market capitalisation to track markets has a number of problems so a fundamental process may be better with a relatively small collection of stocks. Indeed, this seems to be case. Using dividends gave a better capital return of 7% over the same 10 years. One of the main reasons for this is that the dividend-weighted index would have held no RBS from the start of 2009 once it was clear no dividends were to be paid. The dividend version of the index would have held no Cairn throughout this period and would have finished the period with an ever-increasing weight in SSE, a stock that has maintained steady dividend growth throughout the period. SSE would now be close to half the index. In addition this version would offer a much higher historic yield at around 4.9% against 2.1% for the market value based index. That in turn would make it less volatile.

Would this index in any way reflect the relative contributions of various sectors of the economy to Scotland’s GDP? Cairn (at 3%) is the only oil and gas representative in the index, yet this is a major employer in Scotland, though according to the Scottish Government 2007 figures for domestic output, Oil & Gas Extraction only represented 1.7% of total supply, whilst Banking was just 4.2%. Meanwhile the biggest contributors (ignoring Public Administration at 5%) were Construction (7.9%) and Health & Veterinary Services (4.5%), neither of which have any representation in the Scottish index.

This exercise illustrates the difficulty of finding a means to track any particular country. The FTSE 100 index has long since lost any serious connection with the underlying UK economy. A rough rule of thumb seems to be that profits for over 70% of the index are earned overseas. Oil and Gas represents 18% of the index and Mining 10.5% yet these companies operate mainly overseas with many recent recruits coming from the old Soviet bloc.

Digging down into the detail of individual companies shows how difficult it is to allocate economic activity to any particular country. Weir Group as a global engineering company reports its revenues on the basis of the location to which its product is shipped. In 2011 this led to the UK accounting for only 4% of group revenues. This fails to reveal how much of the revenue derived from UK operations, or more precisely, how much of the “value-added” was created in the UK, let alone in Scotland.

So it seems a Scottish index would not be a fair representation of the Scottish economy and represents an extreme case of the inability of a tracker to mirror the underlying economy of any single country. Volatility would be high although a dividend weighted index would have reduced this. A UK tracker might be better seen as a short-cut to a truly global tracker. Indeed the correlation between the UK market and a world index has recently been as high as 95%. A Scottish index would certainly not show anything like the same correlation.


Filed Under: Scotland, Indices, ETFs,

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The Royal Bank of Scotland Group plc (RBS) is a holding company of a global banking and financial services group. The Company operates in the United Kingdom, the United States and internationally through its two principal subsidiaries: The Royal Bank of Scotland plc (the Royal Bank) and National Westminster Bank Plc (NatWest). Both the Royal Bank and NatWest are clearing banks. In the United States, the Company’s subsidiary Citizens Financial Group, Inc. (Citizens) is a commercial banking organization. The Company’s business segment include UK Retail, UK Corporate, Wealth, Global Transaction Services, Ulster Bank, US Retail & Commercial, Global Banking & Markets (GBM), RBS Insurance, Central items, Non-Core Division and Business Services. In May 2012, The Paragon Group of Companies PLC announced the acquisition of further unsecured consumer loans, through its Idem Capital Securities subsidiary, from the Company. more »

Share Price (Full)
361.7p
Change
-1.1  -0.3%
P/E (fwd)
12.2
Yield (fwd)
n/a
Mkt Cap (£m)
41,416

The Weir Group PLC is engaged in engineering businesses. It operates in three segments: Minerals, Oil and Gas, and Power and Industrial. The Minerals segment provides slurry handling equipment and associated aftermarket support for abrasive high wear applications used in the mining and oil sands markets. The Oil & Gas segment provides products and service solutions to upstream, production, transportation, refining and related industries. The Power & Industrial segment designs and manufactures valves, pumps and turbines as well as providing specialist support services to the global power generation, industrial and oil and gas sectors. The Company’s subsidiaries include American Hydro Corporation, EnviroTech Pumpsystems Inc, Gema Industrigummi AB, Linatex Rubber Products Sdn Bhd and Mesa Manufacturing Inc. In July 2014, the Company acquired Metra Equipment Inc. more »

Share Price (Full)
2633p
Change
-12.0  -0.5%
P/E (fwd)
17.5
Yield (fwd)
1.8
Mkt Cap (£m)
5,644

Standard Life plc is a long term savings and investments company. The Company operates in four segments: UK and Europe, Standard Life Investment, Canada, Asia and Emerging Markets and Other. UK and Europe operations provide a range of pensions, saving and investment products to individual and corporate customers in the United Kingdom, Austria, Germany and Ireland. Standard Life Investment provides a range of investment products for individual and institutional customers through a number of different investment vehicles. The operation in Canada provides long-term savings, investment and insurance solutions to individuals and group benefit and retirement plan members. In July 2014, the Company announced that Standard Life Investments (Holdings) Limited has completed the acquisition of Ignis Asset Management Limited from subsidiary of Phoenix Group Holdings. more »

Share Price (Full)
383.48p
Change
-0.6  -0.2%
P/E (fwd)
14.4
Yield (fwd)
4.7
Mkt Cap (£m)
9,192



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Rob Davies is the Fund Manager of VT Maven Smart Dividedn UK Fund, formerly The Munro Fund.. He worked as a professional geologist in Antarctica and Australia before joining the City as a mining analyst. During his 15 years he worked for a number of brokers and investment banks including Smith New Court, Shearson Lehman Hutton and ING Barings. He was a speaker at the Financial Times Gold Conference in 1997 and worked on a number of capital market transactions in the mining industry. From 1999 to 2001 he was a writer at The Motley Fool and co-wrote “The Old Fools Guide to Retirement”. In 2002 he joined the Private Client Department of Clydesdale Bank as Senior Investment Analyst where he was responsible for writing and maintaining investment policy, selecting securities and portfolio creation until the department was sold in 2006. His experience of the stock market as an equity research analyst, personal finance writer and portfolio construction manager has given him a unique background to draw on in crafting this investment process which he now runs at VT Maven Smart Dividend UK Fund, previously known as The Munro Fund. more »



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