Fundsmith Equity Fund records third straight year of underperformance

Returns from the Fundsmith Equity Fund fell short of the global stock market benchmark, the MSCI World Index, for the third time in a row in 2023.

Manager Terry Smith addressed investors in his annual letter last week, where he acknowledged the result but claimed that beating the global stock market is not something that investors should expect from the fund year in and year out.

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Terry Smith is an industry veteran, and his fund’s portfolio typically holds a prominent position among top equity funds on various investment platforms.

In 2023, on the MSCI World Index, despite Fundsmith’s T-Class accumulation shares seeing a 12.4% rise, the fund trailed behind the global stock market, which produced a 16.8% increase.

“While returns were behind the global stock market last year, in absolute terms, they were still robust, so existing investors won’t be too perturbed about the fund’s 2023 performance,” said Laith Khalaf, head of investment analysis at AJ Bell.

Despite Terry Smith’s loyal following and a robust long-term track record, the recent underperformance on both three- and five-year views for Fundsmith Equity Fund may pose challenges in attracting new investors, warns Khalaf.

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So why did the fund underperform in 2023? Firstly, Fundsmith notably excluded Nvidia, a major success story in share prices last year. This stock alone contributed to 11% of the Nasdaq Composite Index’s 43% growth.

However, while in the letter Smith acknowledges the fund’s underperformance last year, he notes, “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.”

“The performance of the Nasdaq Composite Index, which was up 43% in USD in 2023, was dominated by a few companies, the so-called Magnificent Seven—Alphabet, Amazon, Apple, Meta, Microsoft, Nvidia, and Tesla—which accounted for 68% of that index’s gains,” Smith further wrote.

“Nvidia, the designer of chips for use in AI applications, alone accounted for 11% of the 43% gain. We do not own all the Magnificent Seven and would probably not be willing to take the risk of doing so, even if all of them fit our investment criteria,” he added.

He also observes that the stock market has, from the start, chosen winners in AI, such as Nvidia in chip design for generative AI models and Microsoft as an AI model provider. Smith sees this as a departure from tradition, mentioning past early leaders like BlackBerry in smartphones, Yahoo! in search engines, and Myspace in social media that have faded from their sectors.

Top contributors to Fundsmith’s growth

Meta makes its third appearance as a top contributor, while Microsoft marks its eighth, despite facing strong criticism when initially purchased in 2011 at around $25 per share (2023 year-end price of $354).

Other contributors to the strategy’s double-digit growth include Novo Nordisk at 3.6%, L’Oreál at 2.1%, and IDEXX Laboratories at 1.4%.

“Meta Platforms’ (formerly Facebook) performance makes me wonder whether I should have a fund that invests solely in the one stock in our portfolio each year for which we have received the most critical comments. Meta makes its third appearance in this list of top contributors, while Microsoft appears for the eighth time, having attracted strident criticism when we started buying at about $25 a share in 2011 (2023 year-end price of $354),” Smith added in the letter.

Regarding long-term performance and diversification, with Fundsmith Equity Fund managing assets worth £24 billion, Khalaf suggests that Terry Smith remains unfazed, as “plenty of investors are clearly still keeping the faith. All active managers are, of course, prone to periods of underperformance, especially those like Fundsmith, which has a distinct investment style and runs a concentrated portfolio. This is especially true when market leadership is as narrow as it was in 2023.”

He added that “Fundsmith has an excellent long-term performance record and a well-articulated, cogent investment philosophy, which should provide some reassurance to investors. However, Fundsmith’s period of underperformance does highlight why investors shouldn’t put too many eggs in one basket when it comes to active funds. By picking a diversified portfolio of fund managers, others can take up the slack when one falls behind the pack.”

It’s noteworthy that, while Fundsmith didn’t feature in the recent best and worst performing funds for UK investors, it concluded the year in the top 20th percentile overall.

In any way, “investors might have to do some detective work to select successful managers, though, because the global equity sector isn’t exactly full of the rafters of funds that have proved their ability to beat the global stock market. AJ Bell’s manager versus machine report shows that in 2023, only 25% of active managers were able to beat a passive alternative, and that actually falls to 22% on a ten-year view. Fundsmith Equity is therefore actually the exception rather than the rule when it comes to long-term outperformance from an active global equity fund,” said Khalaf.

“Many of these managers have fallen short of simple index trackers because of an underweighting of US equities and large-cap companies and the long-running market trend that has seen these areas of the market perform spectacularly well. A reversal of market fortunes would therefore be welcomed by active managers, but with an increasing share of investment finding its way into passive funds that simply plough money into the biggest companies, that tide might prove difficult to turn,” he added.

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