Terry Smith’s big bet against the passive revolution

As a reader of these pages, it is quite likely that you recently received a letter from Terry Smith, who manages the popular Fundsmith Equity Fund. In it, he set out to explain half a year of, for him, unusually poor investment performance. The headline numbers certainly demand some context and, to be fair to Smith, he makes no attempt to hide or excuse them. The 2.9% fall in the value of his fund in the six months to the end of June compares unfavourably with the 11.2% gain delivered by the MSCI World index over the same period.

Smith pins the blame for his underperformance on a market that has been driven by momentum rather than the fundamental factors like profitability, return on capital and growth that he has - very successfully - focused on since launching the fund in 2010. Even after his recent loss of form, he has delivered a 593% return since inception, compared with the market’s 531%. On an annualised basis, he has provided investors with 13.1% a year, slightly better than the market’s 12.5% over the same period. Please remember past performance is not a reliable indicator of future returns.

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More specifically, he blames a dramatic shift in flows from actively managed funds to passive index trackers over that same period, a move that he argues has negatively impacted the ability of stock markets to correctly price the companies listed on them. Increasingly, he says, the structure of the market itself has become the dominant driver of prices, with potentially calamitous consequences. He doesn’t know how it will end, but he predicts that it will be badly.

The best measure of how passive funds are potentially distorting markets is the margin by which trackers have outperformed active funds over the past five years. According to Smith, Vanguard’s UK All Share tracker has delivered 66% over that period, more than double the 32% return from the average UK equity fund. It is a similar story in the US, where the market has provided a total return of 83% versus 59% for the average open-ended mutual fund.

That is not what passive funds were designed to do. The original sales pitch for trackers was that they would deliver an average performance at a cheaper cost. You would invest in one if you believed that picking the best managers ahead of time was impossible and you expected the higher cost of active management to offset any stock picking skill you might be lucky enough to stumble upon.

The massive outperformance of passive funds in recent years suggests, however, that they are behaving more like their active counterparts, making big sector and stock bets and, in the good years, reaping the benefit. Unfortunately, the dominance of trackers might also be creating dangerous feedback loops that are inflating valuations, making markets less efficient, and increasing the risk that any future correction could be faster, deeper and more unpredictable than today’s complacent investors - lulled by years of outsized gains - are ready for.

There are a few reasons to think that Smith’s analysis doesn’t tell the whole story when it comes to the performance of his fund. His approach of buying high quality companies, not overpaying, and then doing nothing, worked well for years, as it did for others, like fellow quality manager Nick Train. But Smith was probably slow to read the change in the investment weather. Style headwinds are part of the problem. So too is valuation - he held onto companies that could no longer justify their high multiples of earnings. In other cases, he may simply have picked the wrong stocks.

But his basic premise that fundamentally driven investors have a diminishing influence on the direction of stock markets is right. The marginal buyer today is different from a few years ago. It is an ETF buying solely on the basis of market weighting, or a momentum algorithm buying because the price is rising, or a retail investor riding on the coat tails of what has already outperformed. Ironically, in a world of more, and more readily accessible, information, investment prices are being determined in large part by investors who are not interested in making fundamental judgements at all.

The risks are obvious. When the escalator is going up, anyone can jump aboard and believe they have some investment skill. But they are probably just in the right place at the right time. When sentiment reverses, as inevitably it will at some point, there is no way of knowing how far and how fast markets will fall in the absence of price sensitive buyers seeking to arbitrage emerging price anomalies.

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To Smith’s credit, he has avoided the temptation to moan. Rather, he is adapting his approach. He has promised his investors that he will take more account of momentum in his investment decisions. He will be less inclined to buy quality companies when they hit an air pocket. In other words, he won’t assume that he knows better. He understands that the market can remain irrational for longer than he can rely on us leaving our money with him.

What about the rest of us, who don’t carry the burden (or enjoy the rewards) of managing other people’s savings? How should we adapt to investing our own money in a more volatile, more irrational and less predictable market?

First, we too should take account of flows as much as fundamentals. Jim Slater’s growth at a reasonable price approach also included a relative strength filter. He never tried to catch the bottom; he bought when a share was already moving up. Likewise, Anthony Bolton always kept an eye on who else was buying the shares he was interested in. They both recognised that there was wisdom in the crowd. They understood that they didn’t always know best.

Second, we can be diversified. The recent volatility in markets is less a generalised risk-off move than a rotation out of the hottest sectors. In most cases, balance will deliver a smoother ride.

Third, we can know ourselves. Understanding our tolerance for risk is essential in faster-moving and more unpredictable markets. As Mike Tyson noted: everyone has a plan until they are punched in the face.

This article was originally published in The Telegraph.

Past performance is not a reliable indicator of future returns

Source: Morningstar, total returns in GBP terms from 30.6.21 to 30.6.26. Excludes initial charge.

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Important information - investors should note that the views expressed may no longer be current and may have already been acted upon. Overseas investments will be affected by movements in currency exchange rates. Investments in emerging markets can be more volatile than other more developed markets. This information is not a personal recommendation for any particular investment. If you are unsure about the suitability of an investment you should speak to one of Fidelity’s advisers or an authorised financial adviser of your choice.