The best way to invest in British stocks (for the highest returns)

London’s FTSE 100 has been in the doldrums for years, particularly since the technology revolution drew investors’ cash to New York.

But its companies, and the index itself, remain incredibly popular among British investors.

Should you invest? And what’s the best way to boost returns in your Isa or pension?

While performance has been poor – the FTSE 100 had a total return of 79pc over the past ten years compared with 85pc from global stocks – there are plenty of reasons to put your money in this unloved stock market. 

The UK’s main stock index offers excellent international exposure, deriving about 75pc of its earnings from overseas, with a strong tilt to the US. The strength of the dollar against the pound means there is an additional currency gain for investors, since the earnings made abroad are more valuable. This is why when the value of the pound falls, the FTSE 100 typically rises.

The UK stock market can also act as a useful defensive investment. In terms of sectors, its biggest allocations are to healthcare (11pc), energy (11pc) and financial services (10pc) – all defensive industries.  This is why the FTSE 100 has risen as the economic climate has turned sour. 

The index eked out a 0.9pc gain in 2022, during which time the Nasdaq plummeted by 33pc and the S&P 500 fell by 20pc. 

Are you better off investing in larger or smaller UK companies?

The FTSE 100 tracks the performance of the largest companies on the London Stock Exchange. These are generally mature, established companies, so their growth potentially is likely to be lower. 

However, their price volatility is therefore smoother. Unlike some international markets, investors in these large companies can expect to receive the bulk of the returns from dividends, rather than capital growth.

By comparison, the FTSE 250 index is more diversified in terms of types of businesses and sectors. Although the potential for volatility with these businesses is higher, so is the growth potential – which is why the FTSE 250 has historically outperformed the FTSE 100.

Rob Morgan of wealth manager Charles Stanley said there are great opportunities for investors right now in the FTSE 250. 

“Mid cap stocks in the FTSE 250 tend to be more dependent on the domestic picture. In contrast, the FTSE 100 is full of international behemoths – around three quarters of FTSE 100 earnings are from overseas – so the health of the UK consumer or wider economy has less impact on constituents’ profitability.”

He added: “The scope for merger and acquisition activity, something that could be particularly prevalent among FTSE 250 constituents, may provide a boost as we move through the year.” 

The FTSE 250 is also cheaper than the FTSE 100 right now. To work out how expensive an index is, analysts will usually use the “cyclically adjusted price to earnings”, or Cape, ratio. It compares companies’ average annual earnings over 10 years (adjusted for inflation) with their share price. 

The Cape of the FTSE 100 is currently 18.5, which makes it a lot cheaper than the US, which has a Cape of 28.5, but more expensive than the FTSE 250. This index, which is made up of medium-sized companies, has a Cape of 13.8, which is lower than its long-term average. 

Is it better to invest in funds or shares? 

In any market, investing in a company can be highly rewarding but also risky. Even the most promising company can lose its way, plummet in value and leave shareholders with nothing.

By comparison, funds such as “OEICs”, ETFs, and investment trusts allow you to access the stock market and instantly spread your risk across a plethora of different companies. 

“Funds are either managed by a professional fund manager with a defined strategy or designed to simply track an index – such as the FTSE 100 – at low cost,” said Mr Morgan. 

“An ‘active’ equity fund manager typically selects a range of shares, usually 50 to 100, which means less reliance on the performance of any one company. Or, in the case of an index fund or ‘tracker’, the fund simply offers exposure to all the shares in the index.”

You can expect to pay 0.15pc a year in management fees for a passive or tracker fund and 0.89pc a year on average for an active fund.

Remember that charges will eat into your investment returns, which is why it is generally recommended that you use a cheaper tracker fund to access a broader market – like the Legal & General UK 100 Index fund, which charges just 0.06pc a year through Hargreaves Lansdown – and then supplement your portfolio with active funds focused on small and medium-sized companies, or by holding shares in individual companies.  

Another reason to shape your portfolio like this is because research has generally shown active funds focused on medium-sized companies are more likely to outperform passive funds than their larger counterparts. 

The investment platform Bestinvest recommended Mercantile Investment Trust, which is invested in mid- and small-cap firms outside the FTSE 100 and has an ongoing charges figure of 0.47pc a year. 

For income investors, it tipped the Montanaro UK Income fund, which focuses on small- and mid-cap stocks, has an ongoing charge of 0.38pc a year and delivered a yield of 3.9pc in December 2022. 

Remember, you will usually pay higher dealing charges when buying or selling individual shares or investment trusts, compared to funds.

Richard Hunter of investment firm Interactive Investor said the FTSE 100 is full of stocks with real pricing power that have “the ability to pass on costs to the consumer without overly damaging their own volumes”. 

He tipped Diageo – with brands such as Guinness, Tanqueray gin and Johnnie Walker whisky – Unilever and Reckitt Benckiser, the company behind Dettol, Gaviscon and Nurofen. 

“In addition, the potential for a rebound in China’s economy could also augur well for mining stocks, such as Rio Tinto and Glencore, while the oil stocks (BP, Shell) continue to reap the rewards of a relatively high oil price,” he said. 

“With the banks also making higher profits, partly thanks to rising interest rates, which traditionally work in their favour, while also being relatively unaffected by the recent turmoil in the sector, the index is currently providing a host of opportunities for interested investors.”