Fundsmith Equity: a setback for a high-quality portfolio

Rupert Hargreaves explains why investors should focus on Fundsmith Equity’s process rather than its losses last year.

The Fundsmith Equity fund consistently ranks as one of the most popular equity funds among investors in the UK, and it’s easy to understand why.

Managed by star fund manager Terry Smith, since inception on the 1st of November 2010, the fund has produced an annualised return of 15.5% compared to 11% for the MSCI world index (in sterling).

However, 2023 was by far the worst calendar year of performance for the fund since its launch, both in absolute terms and relative to the global stock market.

It lost 13.8% last year compared to a loss of -7.8% of its benchmark.

While disappointing, in some respects, this loss was to be expected. Smith and his team have constructed a portfolio of high-quality businesses, but even these companies weren’t able to escape the challenges of the past 12 months ( it’s not the only fund that’s taken a breather after years of impressive profits). 

What’s more, the fund was coming off the back of a period of exceptional performance. 

Fundsmith Equity returned 25.6% in 2019, 18.3% in 2020 and 22.1% in 2021. Even the most optimistic investor couldn’t expect 20% annualised returns to continue indefinitely.

In his annual letter to investors this month, Smith acknowledged that the performance was disappointing, but he also noted: “no investment strategy will outperform in every reporting period and every type of market condition.”

“It is difficult, if not impossible to find companies which are resilient in a downtown, but which also benefit fully from the subsequent recovery,” he added.

Is the Fundsmith Equity fund heading for trouble?

It’s easy to look at Smith’s record and conclude that last year’s losses are just a blip on an otherwise fantastic track record. 

But, there’s no getting away from the fact that most active fund managers underperform over the long-term and this fund manager isn’t a magician. There’s a good argument to be made that sooner or later his performance will revert to the mean.

Yes, Fundsmith has beaten the market by 4.5% per annum since inception, but could last year’s losses be a sign of things to come?

Investors are also paying the management company 1.04% a year, which is a relatively high fee (you can track the MSCI World index for a fee of just 0.24% per annum). 

Owning a low-cost index tracker fund is a good option for many investors, precisely because active funds can be pretty expensive and often underperform their benchmarks. 

However, research shows that investors are often their own worst enemies when it comes to choosing funds. Studies have shown that investors tend to jump in and out of funds without really giving them a chance. 

According to DALBAR's Quantitative Analysis of Investor Behavior (QAIB) study, which has been analysing US investor behaviour for over three decades, the average fund investor stayed invested for just four years before they jumped to a different fund in the hopes of a better return. 

This lack of patience has a huge cost. Between 1992–2011, the average stock fund returned 8.2% annually while the average stock fund investor earned only 3.5% according to DALBAR data

These figures are a decade old, but that does not make them any less relevant. They show that yes, fund managers might underperform the market, but investors only make a bad situation worse by thinking they know better and moving to other holdings. 

Focus on the quality of the portfolio 

Back to Fundsmith. Smith has earned a strong following due to his honesty with his investors. 

He tries to explain to investors why he owns what he owns, why the companies in the portfolio are better than other businesses and why his three-step investment strategy (1. Buy good companies; 2. Don’t overpay; and 3. Do nothing) is the best way to approach the market. 

Fundsmith has even gone so far as to write an ‘Owner's manual’ to explain to its investors what it’s trying to achieve and how it will achieve it. 

This whole process is designed to help investors focus on the fundamentals of the companies in the underlying portfolio, and ignore short-term market conditions. 

One of the ways Smith does this is with a table in the Fundsmith annual report showing “what Fundsmith would be like if instead of being a fund it was a company and accounted for the stakes which it owns in the portfolio on a ‘look-through’ basis.”

On this basis, at the end of 2022, Fundsmith as a company had a return on capital employed - a measure of profit for every £1 invested in the business - of 32%, double the average of the FTSE 100 and nearly double the average of the S&P 500. It also had a gross profit margin of 64% compared to a mid-40%s range for the indices. 

To put it another way, Fundsmith owns a portfolio of some of the most profitable companies on the market, which are earning almost double their peers on each £1 invested. 

And that’s what investors should focus on. Not the fund’s performance in one 12-month period, but what it owns, and what these businesses could become over the next five, 10 or 20 years. 

The author holds the Fundsmith Equity fund. 

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