Fundsmith Equity posts fourth year of index underperformance

• Terry Smith today published his annual letter to shareholders of the Fundsmith Equity fund
• 2024 was the fourth consecutive calendar year the fund has underperformed the MSCI World Index and the third consecutive calendar year it has underperformed the Global sector
• Large outflows are most likely a result of the fund's size and industry trends rather than investors losing faith in the manager
• Terry Smith and Stephen Yiu (Blue Whale Growth) take opposite sides of the AI trade
• Index funds may be distorting markets, but there's little light at the end of the tunnel for active managers

Laith Khalaf, head of investment analysis at AJ Bell, comments:

"Fundsmith Equity investors have now seen four calendar years of underperformance, though it must be said absolute returns have still been strong over this period. Clearly investors want active funds to outperform all the time, but that simply isn't possible, especially in current market conditions. Indeed the question at present isn't so much whether Terry Smith is underperforming the MSCI World Index, but whether the index is outperforming Smith and his fellow active managers.

"As detailed in our latest Manager versus Machine report, only 18% of active managers in the Global sector outperformed the average index tracker in 2024 to the end of November, and only 17% achieved this feat over the longer, and hence more substantive, period of 10 years. A large part of the strong index performance has been driven by a relatively small number of big technology names, which hold such a high weighting in the index that active managers are unlikely to be anything other than underweight this grouping, known as the Magnificent Seven, as a whole.

Source: FE total return

"Fundsmith Equity is one of the funds which has outperformed a comparable index tracker over 10 years, and has done so comfortably. However investors will still probably be disappointed the fund has also underperformed the average peer in the Global sector in each of the last three calendar years, and is actually a touch behind the sector on a cumulative five year view too (see table above and chart below). Granted there are a fair few passive funds in this sector which have benefited from rapidly rising share prices amongst the very biggest companies in the benchmark index, but the vast majority of funds in this sector are active, and so playing the same ball game.

Source: FE total return

"Investors can draw some reassurance from Fundsmith Equity's longer term performance numbers, and from a clearly framed and executed investment strategy. Those who are attracted to the mantra of 'buy good companies, don't overpay, do nothing' are themselves likely to apply a similar philosophy to the active managers they invest in, so many will undoubtedly stick with Smith through the tougher times, especially when they have enjoyed such long-term success and when recent returns have still been so positive in absolute terms. Conversely, patience is not a creed Smith advocates for management of publicly listed companies, saying the speed of firing executives in the US is part of the reason for its economic success.

What to do about active fund underperformance

"All active managers will undergo periods of underperformance; it's part of the beat. Investors need to be willing to accept sometimes these periods can be quite lengthy. It's always difficult to tell without the benefit of perfect hindsight when an active manager is going through a temporary rough patch, or if there is something more permanently problematic going on. It can help in this situation to assess whether the leopard is panicking and changing its spots by investing in things which don't match up with the stated fund strategy. There is no obvious sign of this at Fundsmith, which is continuing to run a concentrated portfolio of higher quality names with little turnover.

"Active fund investors broadly have the choice of approaching underperformance stoically and sticking with their manager for the reasons they picked them in the first place, or jumping ship when relative returns dry up, which incurs costs and provides no guarantee the new fund will perform any better. You pays your money, you takes your choice. These sorts of decisions over active managers may well explain why so many investors are simply plumping for tracker funds and have done with it.

"It's been widely reported that Fundsmith Equity has seen sizeable outflows this year. That's hardly surprising seeing as it's such a big fund, and active funds in general have been witnessing large withdrawals for the last three years. Not only do active managers have to fight off the land grab of index funds, they also have to compete with savers being lured away by higher cash rates, paying down their mortgage, and even crypto to some extent. Big numbers flowing out of Fundsmith Equity are therefore more likely a sign of the size of the fund and current market trends, rather than investor fatigue with recent performance.

Artificial intelligence and the rise and rise of index funds

"As ever with his annual missive, Terry Smith provides plenty of food for thought on the market at large. He is clearly wary of the AI boom, which must be a somewhat challenging position seeing as some of his portfolio companies, such as Alphabet, Meta and Microsoft, are spending large chunks of cash on artificial intelligence. Presumably Smith sees enough appeal elsewhere in these companies to overcome his doubts over the AI boom.

"It's interesting to note that another global manager with a highly successful track record, Stephen Yiu of Blue Whale Growth, has recently said he has been selling down Microsoft and Meta as a result of their growing AI spend, and has an increasingly less positive view of the other Magnificent Seven stocks, apart from Nvidia, in which he holds a high weighting in his fund. This is the mirror image of Smith, who has shunned Nvidia, but kept the faith with Alphabet, Meta and Microsoft. Active managers of course take different views on stocks and market trends, but the divergent views of Smith and Yiu serve as a useful reminder that the AI boom, which has driven a bull market in US technology stocks for the last two years, does not command a consensus on who the long-term beneficiaries will be.

"Smith also suggests the rise of passive investing is helping to sustain high share prices amongst the biggest companies of the market. That's reasonable enough, though the extent to which passive flows are dominating market performance and creating distortions remains an open question, as does the catalyst which might see this trend go into reverse. Certainly, the strong performance of index funds has boosted their popularity, but they also appeal to investors because of their low cost and their simplicity.

"A lot of the money now invested in passive funds is likely to be sticky and some of it will prove immoveable. The US technology sell-off of 2022, albeit short-lived, was not enough to arrest the popularity of tracker funds. A longer spell of poor performance from the mega cap names of the S&P 500 might shift some money out of passive funds, but if the market is falling, it's more likely to find its way into cash than active funds. It's hard to see how deep the passive rabbit hole will go, but as yet there doesn't look to be much light at the end of the tunnel for active managers."