Fundsmith Equity Fund – Don’t invest without reading this

The Fundsmith Equity fund is one of the most popular UK stock funds right now. And rightly so, because it has consistently outperformed its Benchmark. In fact, at the time of writing its been outperforming the benchmark for nearly a decade.

The benchmark in question is the MSCI World index, which is pretty much a collection of the biggest companies in the world. Over the last 5 years the fund has achieved an annual return of 20% compared to about 12% for MSCI.

It is headed by Terry Smith, who was a well regarded equity analyst prior to starting the fund in late 2010.

He has a transparent and open approach with fees, companies and most importantly the way that Fundsmith invests.

In fact Smith is routinely compared to Warren Buffett due to his investing style. He describes the Fundsmith investment strategy as ‘ODD.’

• Only invest in good companies.
• Don’t overpay.
• Do nothing.

And in that order. Smith’s premise is that, ‘only investing in good companies’ is the most important aspect. That makes sense because in the short term, stocks can have periods where they are undervalued and periods where they are overvalued.

Over the longterm, though, they will move to the correct price. As “Doing nothing,” suggests keeping good companies for a very long time will make money.

Smith and the team like companies with the following characteristics:

• Reasonably well priced;
• Possess some kind of barrier which stops competitors taking market share;
• Don’t need to borrow a lot of money to generate returns;
• Hard to copy; and
• Have a good chance of being able to grow via reinvesting the money they earn at good rates of return

So Fundsmith invests in great, reasonably priced companies, and has provided signification outperformance over a reasonably long time period. What’s not to like?

Well, without doubt the firm has a great track record and investment philosophy but as with anything there are drawbacks.

First of all, it is expensive. The minimum investment in the fund is £1,000, but I’m sure most investors will invest more than this amount. That is because not everyone pays the same for this fund.

The management charges fall into three categories. Investors that just invest the minimum of £1,000 pay 1.55%. Investors who add at least £100 pounds on a monthly basis pay 1.05% and then investors with deep pockets willing to invest at least £1,000,000 pay 0.95%.

That compares to 0.15% you could pay for investing in HSBC MSCI World UCITS ETF (HMWO) i.e. a fund that tracks the benchmark. Of course, up until now, Fundsmith has more than out performed the benchmark. However, if Fundsmith doesn’t continue to outperform, that expense will start to matter.

Mark Dampier, research director of the UK’s biggest broker Hargreaves Landsdown certainly thinks the Fundsmith Equity fund is expensive.

He states this as the main reason it hasn’t made it onto the Wealth 150. A list of the UK’s best funds.

In his own defense, Terry Smith responded by saying:

Hargreaves Lansdown’s recommended funds continue to be chosen mainly for fund managers’ willingness to comply with a charging structure which enables Hargreaves Lansdown to maximise its own profitability, and not because they perform well for investors.

Terry Smith

A second drawback is that Fundsmith Equity is highly concentrated. Concentration can get you higher returns, but higher returns don’t tend to come without risk. It is highly concentrated in both sectors and geographies.

At the time of writing, it focuses heavily in just three sectors: Consumer Staples, Healthcare and Technology. On top of that, the fund only contains 20 to 30 stocks.

You don’t have to read too much about investing to understand how important diversification is. The benchmark MSCI World contains thousands of stocks across many sectors.

Third, Fundsmith might be getting too big for its own good. Warren Buffet is always talking about how if he didn’t have so much money to have to invest he could make better returns. This is a problem for the Fundsmith Equity fund as it gets larger.

If you’ve got £10,000 to invest in 20 stocks then you can just invest £500 in each stock. However if you’ve got £17 billion to invest you are going to have to stick £850 million in each company.

That is a lot of money! If you just invested in billion dollar companies, you’d be investing in 8.5% of a company and that’s a lot.

The bottom line is, the more money you have the more difficult it is to invest it, and unfortunately, it is in the interests of Fundsmith to have as much money as possible. That is because they make money in relation to how much money they have, rather than the performance of the fund.

With £17.5 billion of assets under management they are going to be earning over £117 million a year. Nice work if you can get it, but I bet that won’t stop them wanting more.

Finally, research has consistently shown that investors tend to flock to funds that have done well in the past. But unfortunately, there is a wealth of research out there that shows that funds that have done well in the past are less likely to do well in the future.

In fact, the better they’ve done and the longer the period, the more likely a period of underperformance is just around the corner. You can read more about that here.

There’s no doubt the Fundsmith Equity fund has been a great performer in the past, the problem is, past performance is not a reliable indicator of future performance. Terry Smith may be the active manager that defies the research and continues to out perform the market. On the other hand, he may not.

If you go with the market you are guaranteed to get the market’s returns and the market has in the past proven to be generous. If you don’t go with the market you have a chance to outperform, but at the same time you have a chance of underperforming. Why take the risk?