Growing M&A activity in the UK market now threatens the ability of unit trust managers to find neutr...
Growing M&A activity in the UK market now threatens the ability of unit trust managers to find neutral or overweight positions against the largest five stocks in the index.
The Vodafone-Mannesmann merger took Vodafone Airtouch well past 10% of the FTSE 100, whereas under Ucits, unit trust managers can hold no more than 10% of a portfolio in a single stock.
However, fund managers are now in danger of coming up against a second Ucits rule designed to encourage portfolio diversification. The rule dictates that with no more than 10% in any one stock, the top four can not make up more than 40%, while in the remaining 60%, no single holding can be in excess of 5%. This means the top five could never exceed 45% of the portfolio.
As of 16 May Vodafone Airtouch represented 12.08% of the FTSE followed by BP Amoco at 9.61%.
Glaxo SmithKline, the company to emerge out of the forthcoming merger of Glaxo Wellcome and SmithKline Beecham, would have a representation of 8.39% of the market cap of the two underlying businesses put together. It is followed by British Telecom at 4.64% and HSBC at 4.41%. That is equivalent to a 34.72% weighting for the top four stocks and 38.68% for the top five.
Steven Bell, chief economist at Deutsche Asset Management, said that while many of the problems for the index have come about as the result of M&A activity, there are also fast growing companies which have the potential to dwarf their peers in an index. He cited as an example Nokia, which now makes up 6% of the ex-Europe MSCI index and more than 50% of the Finnish market, as a result of organic growth alone.
Whether organic growth or M&A activity is behind growing stock risk in the index, the difficulties fund managers face are the same.
Following the emergence of the enlarged Vodafone Airtouch, the industry immediately found a solution to the 10% problem through the use of equity-linked structured notes. These were issued in one and two-year versions and are paid off at maturity, at a level reflecting any gains or losses in Vodafone over that period.
These notes were originally issued by HSBC Investment Bank and Deutsche Bank, however Salomon Smith Barney now provide the debentures and other companies may well follow suit.
Mark Dickson, global head of product development at HSBC Asset Management, said: "Because these structured notes are classified as debentures, it does not count as holding Vodafone. It means index tracker funds are able to hold 10% directly in Vodafone, and then make up the rest of their exposure to this company by holding the structured notes, therefore ensuring they minimise the tracking error of their funds.
"Even though these mimic Vodafone, in the case of HSBC or Deutsche Bank-issued structured notes, the purchase of these counts toward the 10% allocation that unit trusts can hold in HSBC or Deutsche Bank."
For example, this means if a manager held 5% in HSBC, but had purchased 3% in HSBC notes to cover the Vodafone holding, the HSBC holding would then equal 8%.
Tracker fund managers expect to use similar structures to overcome the issues of other mega companies. With BP Amoco now representing 9.61% of the FTSE it could very easily tip over the 10% mark if the company continues to grow. This is much the same situation when Glaxo SmithKline enters the LVK indices.
Although access to these debentures means accurately tracking funds should not prove too much of a problem, Dickson pointed out the cost of using such instruments can add up. A further problem can be that a fund manager ends up heavily exposed to debentures issued by a single financial institution and could even have exposure to that company's underlying equity.
FTSE has endeavoured to offer an alternative to using debentures by introducing a capped FTSE 100 and All-Share indices on 8 May this year. However, these have not met with universal approval.
The capped indices, called the FTSE CAP 100 and FTSE CAP All-Share, limit any single stock to 10%. Capped stocks will be reviewed, and the indices rebalanced, on a quarterly basis.
The capped indices will be calculated on an end of day basis at the end of the quarter, while the FTSE 100 and All-Share will continue to be calculated on a real-time basis.
Michael Hayden, retail investment director at Legal & General said capped indices are not the answer and the group will continue to use the debentures. He said: "The problem with the capped indices is these are only worked out on a quarterly basis. Therefore, it could happen that a stock could start at the beginning of the quarter at 10%, but if the value rises this would increase to beyond 10%.
"This would result in forced selling of that stock to stay at the 10% level, or otherwise the tracker fund would have to buy debentures to match the real rise in the stock."
Hayden said the full index is therefore the best one to track and if a cap is going to be applied, then this should be calculated on a daily basis.
Scottish Widows is less critical of the capped indices and is considering launching specialist 'cap trackers', to give clients a choice on tracker products.
Tony Whalley, chief investment officer at Scottish Widows, said the company would also go down the medium term paper route to gain an equal weighting to BP Amoco and Glaxo SmithKline if these stocks go over the 10% mark.
He said: "We are still looking at the idea of launching capped tracker funds but there is still a lot of work to be done. This includes what sort of management fee will be required, customer demand and how we would market the product.
"A problem we face is that there is talk in them media of the FTSE wherever you go. The capped indices don't have the same profile and therefore funds which track these indices won't enjoy a high profile either."
Another major issue, according to Whalley, is the higher management cost