Trustnet - Terry Smith’s four things the industry needs to improve on

One of the industry’s most-held funds, Fundsmith Equity has an enviable track record – it was almost perfect until 2021, when a combination of market forces and two badly timed sales impacted performance.

In the three years since, the fund hasn’t managed to beat the MSCI World index, a reason why earlier this year, it was included in Bestinvest’s Spot the Dog report for the first time.

Below, veteran manager Terry Smith justifies the underperformance against its “dog” status, discusses portfolio turnover and elaborates on the areas where the industry needs to improve.

Performance of fund against sector and MSCI World index over 3yrs

Can you describe your process?

We seek to buy good companies with a high return on capital employed, because that is the financial metric which shows they are creating value, and a source of growth to allow those high returns to be invested and compound in value. We try not to overpay and seek to hold them for the long term.

Why should investors pick your fund?

We aim to run the best fund ever, meaning the one with the highest return over the long term, adjusted for risk.

What were the best and worst calls over the past 12-18 months?

The worst was selling Amazon. We last sold it on 4 May 2023 at a share price of £83 and since then it rose a further 74% – that’s against the 26% growth of the MSCI World index in the same timeframe. At the beginning of June, the price was £145 per share.

The best was holding Meta, which went from £185 to £386, returning 108%. Since we first bought it in February 2018, the share price has risen almost 200% from £129.

Why has the fund underperformed of late?

Interest rates began rising in late 2021 and had a disproportionately large impact on stocks of the sort we own. They are high quality companies and therefore, on average, more highly rated than the market.

But the share prices fare worse than the average when rates rise, just as long-dated bonds fare worse than short-dated bonds in those periods. Also, my sales of Adobe and Amazon could have been better timed.

You bought and sold those two stocks in quick succession. Has turnover increased?

Minimising portfolio turnover remains one of our objectives. Last year it was 11.1%, just a little higher than usual and far less than the average fund manager.

In 2023, we sold our stakes in Adobe, Amazon and Estée Lauder and purchased stakes in Procter & Gamble, Marriott and Fortinet. This may seem a lot of names for what is not a lot of turnover as in some cases the size of the holding sold or bought was small.

We have held 10 of our companies for more than 10 years, five of which since inception in 2010.

What do you make of Bestinvest’s report finding Fundsmith was a ‘dog’ fund?

When Bestinvest issued its report, our main UK competitor's global fund had underperformed Fundsmith Equity by 16 percentage points over the period chosen by Bestinvest but was not rated as a "Dog”, which raises an obvious shortcoming of the methodology.

Also, one of the years included as a period of underperformance was 2021, when the fund returned 22.1%, only marginally behind the MSCI World Index that returned 22.9%. I don’t think many investors were unhappy with a 22.1% return that year.

We think investors should judge our returns over the long term, and since inception the fund is up 594% or 15.3% on an annualised basis, net of fees, compared with 11.8% for the benchmark MSCI World.

What do investors consistently get wrong?

They have too much of a home bias. Why should investors in the UK invest in the FTSE100? The UK is under 3% of global GDP. There is a whole world to choose from.

In what areas does the industry need to improve?

Firstly, transparency, for example making sure that investors can see how much they are being charged – not just in terms of management fees but also charging admin fees direct to the fund and not via the management company, and dealing costs.

Why are there ad valorem charges for some platforms which basically supply software?

Secondly, direct and clear communications explaining fund objectives and what has happened in plain language.

There are also far too many funds and too many intermediaries between the investor and the companies they invest in. Intermediaries always add costs.

What do you do outside of fund management?

I like to keep fit and practice Muay Thai. I have a history degree and still study the subject. I scuba dive.