Terry Smith falls to Earth
The star fund-manager has run into a problem that has dogged active managers for decades
Terry Smith’s Fundsmith Equity fund has underperformed its benchmark, the MSCI World index, by a wide margin over the past three years. In 2023, for example, the global equity fund returned 12.4%, below the 16.8% return for the MSCI World index. Although the £25.4bn fund is beating its benchmark in 2024, its performance since 2020 has led to some tough questions for the fund manager.
Active fund managers are not known for outperformance, and Fundsmith has been the exception to the rule. The latest figures from financial data firm Morningstar showed that in the decade to June 2023, only a quarter of US-based active strategies survived and beat passive alternatives. In Europe, the figure was 17%. Fund manager GMO says that 90% of large-cap blend managers have underperformed the S&P 500 index in the past decade. Mean reversion is a powerful force, and Smith has been pulled back to the average. Following the recent performance, Morningstar downgraded Fundsmith Equity from a gold rating to a silver rating.
Fundsmith’s troubles stem from the fact that active management is hard and it’s worth considering some of the reasons why active managers often struggle to maintain outperformance. Smith’s strategy of finding great companies at attractive prices and holding onto them worked incredibly well. But as is the case with any strategy, there is no guarantee it will continue to work indefinitely. The world changes, and the investment landscape is always shifting.
Investors have to be dynamic and change with the times to capitalise on opportunities when they emerge. That’s one of the reasons active management is so hard to execute. A strategy that has performed well for a decade or more could suddenly look old-fashioned and out of date. Managers often struggle for years before realising they need to change direction.
Costs mount
High fees also affect active fund managers’ returns over the long run. Smith proudly boasts that Fundsmith keeps its fees as low as possible by minimising trading, but it still charges an active-management fee, which goes straight into the fund manager’s pocket; the charge for the class T shares, which most investors own, is 1.04%. This means Smith would have to outperform the market by at least 1.04% every year. That’s hard to do consistently.
Then there is the hubris factor. The percentage of active managers who outperform year after year is tiny, and those who do may, understandably, end up believing they have something special, something that gives them an unrivalled edge. Investors need to maintain a high level of humility at all times and make an extra effort to learn and develop continually. However, often complacency sets in and managers become far too confident about their abilities. There are signs of this creeping in at Fundsmith.
Smithson Investment Trust, a Fundsmith-managed trust launched five years ago to invest in small and mid-cap stocks based on Smith’s investment principles, had to perform an embarrassing volte-face last month after it rejected a continuation vote. The trust’s prospectus says it will consider a continuation vote if its discount to net asset value (NAV) averages 10% or more over a financial year, and during 2023 the average discount was 10.7%. However, the chair of the trust, Diana Dyer Bartlett, argued that the trust was under no obligation to propose a vote at the annual general meeting. This decision caused a storm, and eventually management had to change its mind. A vote will now be held. The debacle was an embarrassment for Fundsmith and it hinted at hubris in the management team. Smithson and Fundsmith Equity are two separate funds. Still, the former’s embarrassing backtracking is an example of when hubris can get the better of an active manager, leaving investors out of pocket.