What Investors Need To Know About The UK Stock Market – Forbes Advisor UK

When people talk about investing in UK shares, they’re often referring to the well-known blue-chip companies that make up the FTSE 100. 

This index is also used as a bellwether for UK stock markets as a whole – thus 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 faring in the crisis.

But there’s a wealth of options beyond the UK’s flagship index, with the potential for superior returns from smaller companies compared to their larger counterparts. 

In fact, investors in the FTSE Fledgling index would have enjoyed a total return of nearly 40% over the last five years, significantly above the 19% return for the FTSE 100.

We’re going to take a look at the different options available to investors across the Main Market and Alternative Investment Market on the London Stock Exchange, together with the investments delivering the highest returns over the last few years.

Remember that stock market investment 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 global stock exchanges, allowing companies and governments to issue shares and bonds to raise money. Once issued, these shares and bonds can be traded by institutional and private investors.

The LSE has two markets: the Main Market and the Alternative Investment Market (AIM), which differ by the types of companies listed and their respective regulatory requirements.

1. Main Market

Over 1,300 companies from 70 different countries are listed on the Main Market, including Shell, AstraZeneca, HSBC and Unilever. Companies are required to meet stringent regulatory requirements before their shares can be listed on the Main Market.

That said, the City 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 bourses. 

This included a reduction in the ‘free float’ (shares available to the public) from 25% to 10%, but an increase in the minimum market capitalisation from £700,000 to £30 million.

The Main Market also includes three segments covering high-growth companies, specialist funds and premium companies (with higher listing standards). 

2. Alternative Investment Market (AIM)

AIM, also known as the ‘junior market’, was established in 1995 as an alternative market for small and medium companies to access funding. 

Over 1,200 companies are currently listed on AIM, including the holiday provider Jet2, retailers BooHoo and Hotel Chocolate and market research provider YouGov. 

Why do companies choose to list on AIM? Principally due to the lighter regulatory requirements, which are less expensive and time-consuming than those on the Main Market. 

There’s also no minimum ‘free float’ or market capitalisation, and, unlike the Main Market, companies are not required to have a three-year trading history. 

As a result, AIM tends to attract higher-growth companies in an earlier stage of development – according to Grant Thornton, AIM companies achieve an average revenue growth of 40% in their first three years following their initial public offering.

However, AIM is no longer just for smaller companies and includes a number of companies with a market capitalisation of over £1 billion. Companies such as ASOS and Domino’s Pizza started out on AIM before moving up to the Main Market. 

What do investors need to know about indices?

There are a range of indices on both the Main Market and AIM which 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 capitalisation (‘market cap’) has risen sufficiently. 

However, a threshold is set for ‘promotion’ for each index to safeguard the stability for the companies listed in the indices. For example, a company needs to have risen to at least 90^th to be added to the FTSE 100, or have fallen to 111^th or below to be deleted.

Being added to a higher index tends to have a positive effect on a company’s share price as index tracker funds will be required to buy its shares to replicate the index. However, the opposite is true for ‘relegated’ companies who may suffer a ‘double hit’ to their share price.

Here’s some of the most popular indices for the Main Market:

1. FTSE 100

The Financial Times Stock Exchange (FTSE) 100 is the gold standard of the LSE indices, and often used as the barometer for the wider UK stock market.

It comprises the hundred largest companies listed on the Main Market by market cap, with an average value of £20 billion. Currently, AstraZeneca is the largest company in the FTSE 100, with a market cap of over £170 billion, with Harbour Energy at the other end with a value of £3 billion. 

The FTSE 100 is heavily focused on blue-chip stocks in the commodities, financials and consumer staples sectors. FTSE 100 companies include Shell and BP in oil, Anglo American and Rio Tinto in mining, and HSBC and Barclays in the banking sector.

The larger cap companies have a higher weighting in the index – for example, Shell and AstraZeneca each have a current weighting of 8%. As a result, any price changes in the share price of these companies have a significant impact on the index as a whole.

The FTSE 100 also has a strong international focus, with over 75% of revenue coming from overseas, according to FTSE Russell. What’s more, companies such as BP, Shell, HSBC and AstraZeneca report their results in dollars as most of their transactions are conducted in dollars rather than pounds.

2. FTSE 250

The FTSE 250 comprises the 101^st to 350^th largest companies by market cap, with a considerably lower average value of £1.4 billion than the FTSE 100.

The FTSE 250 covers a wider range of industries and has a more even weighting than the FTSE 100, with no company accounting for more than 1% of the total index. 

In contrast to the FTSE 100, only 50% of revenue is earned overseas – as a result, the FTSE 250 is a better indicator of the overall health of the UK economy due to its domestic focus. 

Medical products provider Convatec is the largest company in the FTSE 250 at £4.5 billion, with the smallest being Hochschild Mining at just under £430 million. 

3. FTSE 350

The FTSE 350 covers the largest 350 companies listed on the Main Market, and is simply the FTSE 100 and 250 combined. The average market cap of the FTSE 350 companies is £6.7 billion.

4. FTSE Small Cap

The FTSE Small Cap contains the companies from the FTSE All Share Index which are not large enough to qualify for the FTSE 350. In other words, the 351^st to 600^th largest companies by market cap.

Top of the index is real estate company Home REIT with a market cap of over £900 million, with kitchenware company Procook bringing up the rear with a market cap of £42 million.

5. FTSE All Share

The FTSE All Share is the aggregate of the FTSE 100, 250 and Small Cap indices. The 600 companies included in the FTSE All Share Index account for 98% of market capitalisation in the UK Main Market indices.

6. FTSE Fledgling

The FTSE Fledgling Index covers the 77 companies that are too small to be included in the FTSE All Share, with the majority being investment trusts and other finance companies. The average market cap is £50 million, with a range of £1 million to £170 million.

There are fewer indices for AIM, but the main ones are:

1. FTSE AIM UK 50 Index: the top 50 AIM companies by market cap, with an average market cap of £590 million. Life sciences company, ABCAM, is the largest in the AIM 50, with a market cap of £2.8 billion.

2. FTSE AIM 100 Index: the 100 largest companies on AIM, with an average market cap of £495 million. 

3. FTSE AIM All-Share Index: covers over 760 AIM companies, with an average market cap of nearly £100 million. 

Which indices have delivered the highest returns?

Smaller cap indices tend to perform better than larger rivals in an economic boom due to their higher growth potential. Or, as investment expert Jim Slater put it: “Elephants don’t gallop.” 

The smaller cap indices also tend to be less well-covered by analysts, which may appeal to investors hoping to unearth the next big growth story. 

However, larger cap indices tend to be more resilient in an economic downturn, partly due to their larger financial reserves, but also due to their focus on overseas markets, rather than just the UK. 

Let’s take a closer look at the relative performance of the main indices over the last 5 years to see whether 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 the small cap indices delivered better returns than the large cap indices, the FTSE 100 comfortably outperformed the FTSE 250 with a five year return of 19% and 9% respectively.  

Much of this difference is due to their performance over the last year, with the FTSE 100 dropping by 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 taking its toll on the index. Similarly, the strength of the US dollar against the pound has helped the FTSE 100 companies with significant overseas earnings. 

The FTSE 100 index has also been boosted by the bumper profits earned by the energy companies such as Shell and BP.

That said, returns are only one 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 the volatility and the risk of losing money. 

1. How does volatility vary by index?

One measure of risk is volatility, in other words, the extent to which share prices move up and down. High volatility can make it harder for investors to time their purchases and sales. 

Smaller companies usually experience more volatility in share prices as they have more limited financial resources to draw on in an economic downturn. This can make their share price more vulnerable to negative investor sentiment in bearish stock markets.

Susannah Streeter, senior investment and markets analyst, Hargreaves Lansdown comments: “Getting in early in a company’s growth cycle has the potential of reaping significant rewards over the longer term but these stocks also carry greater risk.” 

She also warns that small cap companies “can be subject to much heavier speculation, which can lead to over-valuations.”

Looking at the monthly changes in the indices over a five year period, FTSE Russell reports that the larger cap FTSE 100 had the lowest volatility of 14% and the FTSE Fledgling the highest at 19%. 

However, the exception to the rule was the FTSE 250, which experienced higher volatility than the FTSE Small Cap. One reason is the higher proportion of investment companies, such as investment trusts, in the FTSE Small Cap, which are actively managed to reduce volatility for shareholders.

2. How does the risk of making losses vary by index?

While investors will want to make money in rising markets, it can be equally important to protect investments in a stock market downturn. We’ve 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 far more mixed performance in 2020. While both the FTSE 100 and 250 delivered losses, the FTSE Small Cap and Fledgling bucked the falling stock market to achieve positive returns of 7% and 11% respectively.

Overall, despite the smaller cap indices experiencing higher volatility, they managed to weather the stock market downturns better than their large cap counterparts.

How can you invest in the UK stock market?

There are two main ways of investing in the UK stock market – buying company shares directly or investing indirectly via a fund, investment trust or exchange-traded fund (ETF).

You can buy these products in a general investment account. Alternatively, you could buy and hold them in a tax-efficient ‘wrapper’ such as an Individual Savings Account, Self Invested Personal Pension or Junior ISA.

1. Buying shares in a company

You should be able to buy most shares on the Main Market or AIM through a trading platform, such as Hargreaves Lansdown or AJ Bell. We’ve compiled a list of the best trading platforms to compare the different fees and features of the main providers.

However, there is a difference in the price and ease of buying larger cap stocks. Large cap stocks have high trade volumes which means that it’s easy to buy and sell your shares. You’ll also pay a low ‘buy-sell’ spread.

In contrast, small cap stocks are generally less liquid – in other words, they’re harder to buy or sell quickly without having a significant impact on the share price. This has a knock-on impact on the price and can also create an issue when you are trying to sell shares (if you have to lower the sale price to attract a buyer).

Let’s take a look at a couple of examples:

• Barclays is a FTSE 100 company, with a current daily trading volume of over 28 million shares. My trading platform is quoting a buy-sell spread of 150.96 (sell) to 151.04 pence (buy), a difference of just 0.05%. In other words, if I pay 151.04 per share, I’d need the share price to rise by only 0.05% to ‘break-even’ if I wanted to sell my shares.

• Topps Tiles is a FTSE Small Cap company, with a trading volume of around 53,000 shares a day. The buy-sell spread is currently 39.0 to 41.0 pence, a difference of nearly 5%. Therefore, the sell price would have to rise by 5% to equal the purchase price of 41 pence per share. Due to the much smaller volume, the trading platform charges a higher ‘margin’ on less liquid shares.

Most, but not all, trading platforms charge a share dealing fee for buying or selling shares, usually a flat fee of between £5-10 per trade. You will also have to pay stamp duty of 0.5% on the value of the transaction. 

You may also have to pay an annual platform fee for holding shares, typically charged as a percentage of the value of your shares.

Investing in individual shares in a small cap company may provide the potential for high returns, but is also higher risk than investing in a FTSE 100 company. However, investing in a collective investment product, such as a fund, should reduce the risk of an individual company underperforming.

2. Investing indirectly in the UK stock market

Investment products such as funds, investment trusts and ETFs provide a ready-made portfolio of UK shares. There are two main types:

• Passive investmens: these 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 covering the FTSE 100, 250 and All Share indices, but not the Small Cap and Fledgling indices. 

• Active investment: these charge a higher fee of around 0.4% to 1.0% as they are actively-managed by a fund manager. There is a wider choice of active investments for smaller cap funds than index tracker funds.

Depending on the type of product, you may pay a flat dealing fee for buying and selling these products, along with a platform fee.