Fundsmith Equity fund underperforms again - is it still a winner?

Fund veteran Terry Smith has underperformed for the third successive year. Is it still worth backing his high-quality portfolio?

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The Fundsmith Equity fund is a favourite among investors and while regularly posting positive returns, it has underperformed the MSCI World Index over a five-year period.

The portfolio, run by industry veteran Terry Smith, regularly ranks among the top equity funds on investment platforms.

It posted a return of 12.4% in 2023 and is up 73% on a five-year total return basis to the end of February 2024.

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Most investors would be happy with that but the MSCI World Index in comparison is up 82.5% over the same five-year period., which is positive for investors but behind the MSCI World Index, which was up 16.8%.

Its 2023 returns mark the third calendar year of underperformance for the fund but it is an improvement on 2022 when it was down 13.8%.

Despite this, the Fundsmith Equity fund was included in Bestinvest's Spot the Dog report of underperforming funds for 2023, although the asset manager has queried the methodology.

Analysts highlight that many active fund managers have struggled amid the strong performance of the "Magnificent seven" technology stocks, some of which FundSmith avoids.

The fund is still up 15.3% annually since launch in November 2010, so investors who have stuck with the fund over the long term have made a profit.

Fundsmith's performance in 2023

Smith has acknowledged the fund’s underperformance compared with the MSCI World Index in his annual letter to shareholders.

This was attributed to the recent boom in technology stocks and artificial intelligence (AI).

“Outperforming the market or even making a positive return is not something you should expect from our fund in every year or reporting period, and outperforming the market was more than usually challenging in 2023,” adds Smith.

He says the performance of the Nasdaq Composite Index, which was up 43% in 2023, was dominated by the so-called magnificent seven — Alphabet, Amazon, Apple, Meta, Microsoft, Nvidia and Tesla — which accounted for 68% of the index’s gains.

Computer chip maker and major AI player Nvidia alone accounted for 11% of the 43% gain.

Smith explains that his fund doesn’t own all the magnificent seven and would probably not be willing to take the risk of doing so, even if all of them fitted his investment criteria.

He also expressed some pessimism about the strength of the AI market, suggesting the adoption may lead to a situation where everyone has it, so no one has any advantage.

“The analogy I would offer - with acknowledgement to Warren Buffett - is a football stadium, he says.

“As the game becomes exciting and the striker runs into the penalty area with the ball, the second row of spectators stands up to get a better view. This blocks the view of those in the third row who follow suit. Pretty soon all the spectators are standing but no one has a better view than before, but they are all less comfortable.”

Smith says it is important to take a long-term perspective, that is more consistent with the fund’s investment aims and strategy.

Since inception in November 2010, the fund has returned almost 4% more per year than the MSCI World Index on average, says Smith, with lower levels of volatility.

The fund is also the best performer since its inception in November 2010 in the Investment Association Global sector of 165 funds, with a return 335 percentage points above the sector average, which has delivered just 215% over the same timeframe.

The Fundsmith Equity fund's worst performer for the year was Estée Lauder, which pushed the portfolio down 1.8%.

Smith said the fund has since sold its stake in Estée Lauder, adding that the company's mishandling of the demand and supply situation in China following reopening post-Covid and in the travel retail market “revealed serious inadequacies in its supply chain".

Other losses came from McCormick, Diageo, Mettler-Toledo and Brown Forman.

Technology stocks dominated the fund’s top performers in 2023.

Facebook owner Meta Platforms was the top performer, pushing the portfolio up 4.5%. 

The other top performers were Microsoft, Novo Nordisk, L’Oréal and IDEXX Laboratories.

Is it worth investing in the Fundsmith Equity fund?

Terry Smith has a loyal following and a strong reputation and with assets under management of £22.7 billion, unlikely to be too worried about investor outflows.

It was the most-purchased fund on the interactive investor platform during 2023, although it slipped from first to fourth place towards the end of the year.

"Although Fundsmith Equity has slipped down our fund bestsellers table since it was knocked off the top spot in October, what has not changed is that Fundsmith Equity remains very popular with our customers,” says Kyle Caldwell, collectives editor at interactive investor.

“Smith focuses on high-quality companies, meaning firms with established businesses, reliable profits and steady growth, which should also be able to withstand an economic downturn.”

Laith Khalaf, head of investment analysis at AJ Bell, highlights that 80% of global funds have outperformed the MSCI World Index.

Meanwhile, the Fundsmith Equity fund has still outperformed its peers, with the average global fund up 61.7% over five years.

Fundsmith Equity has also outperformed the MSCI World Index over 10 years, up 329% compared with 215.5%.

Khalaf warns that it can be hard to find active funds that outperform though and many struggle to beat trackers. 

He says investors should always expect periods of underperformance and it is important to put the fund's returns in context and to consider its prospects.

For example, most active fund managers have struggled to outperform amid the boom in technology stocks in the US.

"There are no signs of Fundsmith deviating from its well-articulated investment philosophy," adds Khalaf.

"Anyone who has followed the fund for any length of time will not be surprised to find Terry Smith sticking to his guns. In their deliberations investors should revisit the reason why they bought the fund and whether the investment case still holds water. 

"They should also consider whether there have been any changes in their personal circumstances or the rest of their portfolio which might affect the suitability of a global equity fund like Fundsmith Equity."

Marc Shoffman
Contributing editor

Marc Shoffman is an award-winning freelance journalist specialising in business, personal finance and property. His work has appeared in print and online publications ranging from FT Business to The Times, Mail on Sunday and The i newspaper. He also co-presents the In For A Penny financial planning podcast.