Terry Smith: ETF flows threaten emerging markets

Fundsmith star was surprised to outperform the MSCI index

Terry Smith has said that he is surprised the Fundsmith Emerging Markets Trust has been able to outperform its benchmark given the effect of exchange-traded fund flows on the asset class.

While the share price on the investment trust fell 9.4% over 2018, just behind the 9.3% falls in the MSCI Emerging and Frontier Markets index, the net asset value fell just 3%.

Smith pointed out in the closed-ended fund’s annual report more than 100% of inflows into emerging markets since 2015 have gone into ETFs, which differs significantly from his portfolio in its composition.

He said: “None of the top 10 constituents of the MSCI Emerging and Frontier Markets Index, which collectively represent 23% of that index are, in our opinion, of sufficient quality for inclusion in our company’s portfolio, as they consist of Chinese banks, a Chinese insurer, ecommerce platforms, consumer electronics and semiconductor manufacturers.”

Feet versus MSCI Emerging and Frontier Markets sector allocations

Feet sector split

Weight %

MSCI sector split

Weight %

Consumer staples

69.7

Financials

25.2

Health care

13.8

Communication services

14.1

Consumer discretionary

6.3

IT

14.0

Information technology

3.7

Consumer discretionary

10.2

Materials

3.3

Energy

7.9

Industrial

2.9

Materials

7.6

Cash

0.3

Consumer staples

6.8

Industrials

5.5

Real estate

3.2

Health care

2.8

Utilities

2.7

Total

100

100

Source: Fundsmith

Cyclicality, leverage, opaque accounting, lack of clear ownership rights, technological obsolescence and inadequate financial returns were reasons he listed for not holding these companies. “None pass the muster,” he said. Instead he seeks companies with returns on capital, profit margins and growth superior to the companies in the benchmark.

Returns in the MSCI index were also extremely concentrated with 32% coming from Tencent (and Naspers which owns a stake in Tencent), Alibaba and Samsung, “none of which we own or wish to own” he said.

“Faced with this background, I am pleasantly surprised by how the FEET portfolio performed.”

Feet versus Fundsmith Equity

In fact, Smith said his flagship global equity fund was a better benchmark for his emerging markets product than the MSCI index because it takes a similar investment approach albeit in developed markets.

He said: “It is interesting that the stocks in Feet are only about 12.5% more expensive than the stocks in the Fundsmith Equity fund, which had a free cash flow yield of 4% at the end of 2018.

“Yet the returns they are generating and the revenue growth they are delivering are materially higher.”

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