Alistair Cunningham financial planning director at Wingate Financial Planning kicked off a Twitter venting session last Friday describing his frustration “trying to explain to a layperson the extreme risk Fundsmith Equity funds pose”. He compared Smith’s fund with Henderson Global Tech, a fund that was almost obliterated after the dotcom bubble burst.
Cunningham said he had had “scary” conversations with two investors recently, one of whom has their entire pension invested in Smith’s fund.
“I’ve had two conversations in the last fortnight that worry me: one very long-term holder of the Fundsmith fund who has all his pension in (£1m) and won’t bail out, and another well diversified, who’s envious of the returns and thinking of jumping. Scary.”
Putting all your eggs in one basket
Clarifying his comments later on, Cunningham says that 10 years of a virtually uninterrupted bull market people had created “over enthusiastic” investors.
“People who don’t typically invest start to, which is a bad thing, and people who already invest tend to get overly confident.” As a result, you get “things like very big holdings in high risk funds or worse putting all your eggs in one basket,” he says.
Darren Cooke, director of Red Circle Financial Planning, who also weighed in on the Twitter thread, says he would be concerned if his clients had all their money in one fund, especially one like Fundsmith Equity “that isn’t particularly well-diversified”.
Adrian Lowcock head of personal investing at Willis Owens says the situation of investors buying only one fund is not common “but sadly does happen”.
Call to the star manager
A far more typical scenario is investors who have too much in one fund to the point where they are not really diversified. Lowcock says he witnessed this frequently with investors who piled into Woodford’s funds before and after he left Invesco Perpetual.
Cooke says there is always an element of “the call to the star manager” driving investor fund selection behaviour. “It’s human nature to see someone being successful and to follow them,” he says.
He says Smith could easily fall down the route of other star managers like Woodford and former Fidelity man Anthony Bolton and “come unstuck” if there was a blow-up in US markets or the tech sector, areas in which the fund is heavily invested.
“I’m not saying that’s likely but if it did happen how nimble would Terry Smith be to get the clients’ money out? History shows us that active managers are no better than the rest of us at managing behavioural biases. They tend to suffer just as badly as anyone else.”
Flavour of the month
Cunningham says Smith’s fund is another “flavour of the month” like Neil Woodford’s equity income fund was four or five years ago. But he sees more similarities between Fundsmith Equity and the Henderson Global Tech fund.
Technology companies now make up 35% of Fundsmith Equity, including four of its biggest holdings – Paypal, Amadeus, Microsoft and Facebook. However the fund also has chunky positions in consumer staples and healthcare, which comprise 25.3% of the portfolio each.
Lowcock disagrees that Fundsmith is comparable to Henderson Global Tech during the dotcom bubble. Unlike the tech companies of the 90’s that had no return on equity (ROE) and were unprofitable, Smith’s tech investments are “fairly well established players or dominant in their field,” he says.
“As Smith clearly states he buys good businesses and valuation is the secondary concern, but that quality focus means he will likely avoid the more speculative technology companies that bought down many tech funds.”
US bias cause for concern
Both Cunningham and Cooke highlight the fund’s high correlation to the S&P 500 and bias toward US equities as areas of concern.
Cooke believes Fundsmith Equity barely counts as a global equities fund considering over 60% of the portfolio is held in US equities, with less than one fifth held in the UK (18.10%) and smaller positions in individual European markets. Around 40% of the fund’s US companies derive their revenues from outside America.
Fundsmith Equity has a 0.85 correlation with the S&P 500 in sterling terms, according to data from FE Analytics. Its correlation with the S&P 500 Information Technology sector index is even lower at 0.79 in sterling terms.
The Smithson Trust, which invests in small and mid-cap companies, would not have the same large-cap correlation as Smith’s equity fund.
In terms of total returns the S&P 500 IT has outpaced Fundsmith Equity, delivering 233% versus the fund’s 165% over five years. The S&P 500 has returned 115% over the same time frame.
Phil Stockton, director at Private Capital, adds if growth-style stocks suddenly fall out of favour the fund will take a hit.
Fundsmith Equity has 60.32% invested in large growth stocks compared with the FTSE All-Share’s 19.21% weighting, according to data from Morningstar.
“No idea when the wheels will fall off but fall off they shall,” he tweeted on Friday.
Smith’s lack of experience in an unfavourable market environment was one of the reasons Hargreaves Lansdown says it has not added Fundsmith Equity to its best buy list of funds, Wealth 150+.
The broker says the fund hasn’t yet been tested during a prolonged market fall or an environment where the star manager’s growth style is out of favour and says his eight-year career in fund management is “still relatively short compared to other successful managers in the global sector”.
Some correlation is desirable
Peter Sleep, senior portfolio manager at 7IM, says it is unusual to look at correlations when assessing a fund.
He says given Smith’s fund is underweight Japan, one of the largest equity markets in the world, and underweight value, “present in spades in Japan and Europe,” it is unsurprising that it has good correlations with the US.
But he doesn’t see this as a bad thing, noting that all equity markets are fairly closely correlated with the US anyway.
“If you think about it, some correlation is desirable as equity markets tend to go up over in the long term, and you want a piece of that, and a bit more if possible,” he adds.
That said, Sleep says he would not describe Fundsmith as particularly risky for a fund that invests 100% of the portfolio in equities. He notes it has an historical beta of 0.8 to the MSCI World index, which suggests that it will be about 80% as volatile as the benchmark.
He adds the fund is “reasonably well diversified internationally and sector-wise unlike some of the thematic ETFs that are now popping up”.
“The fund has performed well I think because it has really caught the zeitgeist of the last few years with its focus on profitable, high ROE, steadily compounding growth stocks,” he says. “These stocks have gone from being unloved in the mid-noughties to being possibly over-owned now and there may be some risk of mean reversion in the short term, but I am confident that this strategy will continue to work well in the future.”