How the FTSE 100's dividend could hobble the index

The FTSE 100 has made little progress above the 6,000 - 7,000 level for the past 20 years -- at times, it's been much lower.

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Wigglier than a fiddler's elbow

We first saw the index flirting with 7,000 during the tech bubble in 1999. Since then we've had the massive decline to below 3500 -- the so-called "tech wreck" -- as the index's wild overvaluation normalised.

Then there was a personal and corporate debt-driven boom, which combined with an up-phase in the commodity super-cycle to propel the index back up to near 7,000 during 2007.

The credit crisis led to a revisit of 3,500 in 2009.

Economic stimulus measures administered by national governments around the world helped to propel the FTSE 100 back up to 7,000 during 2015, but by early 2016, we were down to around 5,500 again, driven largely by a collapse in commodity prices.

The FTSE 100 has provided investors with a wild ride over the past couple of decades, and mistiming a jump into an index tracker will have led to a poor investing outcome.

Is the index cheap?

As practising value investor and investment author John Kingham observes, the FTSE 100 sits on a cyclically adjusted price-to-earnings ratio (CAPE) of just over 12. The long-term average for the index is somewhere in the mid-teens, which raises the tantalising prospect that mean-reversion could see the index realise upside potential from here.

There's a problem, though.

John Kingham points out that the earnings of the constituent companies of the FTSE 100 do not cover the aggregate dividend of the index -- for the first time in around 30 years. For the current generation of investors, that's probably uncharted territory.

Well-known fund manager Neil Woodford warned us earlier in the year that he expects dividend cutting to be a big feature of the investing landscape during 2016. The big question is, will dividend-cutting activity sink share prices, or is the market already factoring in such payout reductions? We can never be sure.

The closet cyclical

Simple FTSE 100 tracker funds reproduce the index by weighting. An investment, then, relies mainly on the fortunes of the largest constituents of the index. That's not good, because around 70% of the money we invest in a FTSE 100 tracker ends up allocated to around just 30 companies, many of which are cyclical commodity firms and financial organisations.

Investing in a FTSE 100 tracker is like investing in a closet cyclical firm and cyclicals can be unpredictable and volatile, often not getting anywhere at all over the longer term. That's why we see such volatility and such macroeconomic sensitivity in the FTSE 100 index.

Right now, I'm wary of big cyclical investments because after a long period of strong company earnings the risk of earnings and share price collapse increases. Simple valuation measures such as price-to-earnings ratios can let us down with the cyclicals, often making investments look cheap precisely when they are at their most dangerous.

I'm not pinning my hopes on mean-reversion-of-valuation lifting the FTSE 100 index. Instead, I think there is better value lurking in the smaller 70 or so firms that attract around 30% of our invested money in a FTSE 100 index tracker. Many of these smaller constituents of the index are less cyclical than their larger peers and have better growth prospects.

Are you looking for decent shares?

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Kevin Godbold has no position in any shares mentioned. The Motley Fool UK has no position in any of the shares mentioned. We Fools don't all hold the same opinions, but we all believe that considering a diverse range of insights makes us better investors.