With Terry’s net worth reportedly estimated between £300m to £1bn, that’s clearly tongue in cheek from me! However, Terry Smith’s annual letter to Fundsmith investors caught Nick’s and my attention this week, to the extent that I am going to use it to explore several investing and fund manager selection issues.
Fundsmith Background
Terry’s Fundsmith Equity fund launched in 2010 and shot the lights out in terms of performance and funds attracted. At one point, the fund managed £29bn and was the largest UK retail investment fund.
The first decade for Fundsmith went very well!
Source: Morningstar, Total Return in GBP, 01/11/2010-31/12/2020
A 458% return in a decade, more than twice the global equity index return, it seemed Terry had cracked the code for active investing based on his three mantras lifted here from his recent newsletter:
- Buy good companies
- Not overpay
- Do nothing
It has been a very different picture in the last 5 years.
Source: Morningstar, Total Return in GBP, 10/07/2021-09/07/2026
Fundsmith Equity has made just 10% in the last 5 years versus a global equity index return of just over 80% and investors are voting with their feet. Despite making 10% in growth, the fund’s assets have dropped more than half from £29bn to £12bn.
By the time we were selecting global equity managers at Tideway, Fundsmith Equity was already too big for us. Managing funds actively above £10bn comes with challenges as the amounts you need to buy and sell relative to the free floated shares in companies grows. Nor did we like the cost of the fund. We did not have enough assets to get a special rate with Terry’s fund and at 1% p.a. it is just too much to pay for this kind of fund.
We pay 0.45% for a similar strategy fund with the Dundas Global Investors fund, Heriot Global, who, whilst still under performing the world index over the last 5 years, has delivered three times the return of Fundsmith Equity.
What the Investor Letter Says
Terry’s most recent letter is a defensive response to a -2.9% decline against an +11.2% MSCI World gain for the last 6 months – underperforming yet again.
Terry notes a strategic shift towards increased portfolio turnover and sensitivity to momentum while maintaining a focus on quality companies. He reveals a massive 52% turnover in the fund portfolio in just 6 months.
Terry also highlights market distortions from passive flows, momentum traders and AI enthusiasm quoting heavily from Simon Evan-Cook’s recent Substack post and warns of the potential for an ugly end or reset in passive investing.
Tideway’s Dissection of the Letter and Lessons Learned / Reinforced
We agree with Terry and Simon Evan-Cook’s assessments and warnings of the distortions caused by passive investing. Passive investors are now the largest equity market participants and along with momentum traders of various sorts dominate daily trading and don’t care about the quality of a business or its valuation. Terry and Simon’s arguments are compelling and rather than me retelling them we have added links below for those interested to read them.
We do think there is a substantial risk that the increase in passive investing will at some point lead to, at best, a period of relatively poor returns from the indices versus good active managers, and, at worst, a market crash. However, we see AI continuing to feed and even accelerating the passive investing trend unabated in the short term. This is something that could help the market indices to behave irrationally for much longer than many active investors might believe. Just have a go with Google’s Gemini, asking a few questions on investing, and sooner or later you will get advice (unregulated!) to invest passively.
We are not convinced blaming poor returns entirely on passive and momentum investors holds water. We have several active managers who have outperformed the world index in the last 5 years and several who have kept pace with it, none of whom have ‘hugged’ the index as the only way to generate great returns. The lack of humility to admit mistakes made is typically Terry, but probably not great news for his investors.
We do think it’s the No 3 mantra – ‘Do nothing’ which has been the undoing of the fund. The rationale to invest in the 2010 portfolio was clearly good. The subsequent return on that portfolio with the swelling of Fundsmith and other ‘quality growth’ managers pouring money into the same companies was fantastic. But with the benefit of hindsight, it is easy to see that this pushed those companies values too high and, without a valuation discipline to take profits, the fund has suffered, as those valuations have returned to earth, as reported profits disappointed versus the earlier expectation of accelerating profits.
The change in strategy and portfolio turnover is a huge red flag to us. This is not style drift, it is Terry’s style falling off a cliff! This is exactly the sort of thing we watch for closely with our managers and we don’t buy Terry’s reasoning behind the changes. If we owned the fund in 2026, we would certainly be selling after this letter but would have hopefully picked up the ‘off piste’ activity well before the letter.
It is point 4, combined with the impact of a fund, which turns from cash flow positive to cash flow negative and becomes a forced seller every day, that are the two big tells as to what could ultimately happen to passive index investors one day.
I was present at a presentation from the Dundas team last week and the contrast was stark. Clearly conscious of the poor relative returns to the index, rather than turning over the portfolio, they had conviction to continue to hold their selected portfolio and could see value as and when valuations caught up with increasing profits and dividends after a period of being out of fashion versus US big tech.
Looking at their portfolio and others in Tideway’s selection of global managers, what hits me is how different they are to the index. This is not small tweaks here and there to gain an edge on the index; this is chalk and cheese. Whilst the jury is out as to which will perform the best in coming years (I’m with Nick and our active managers in thinking that the index faces some big challenges from here), there can be absolutely no doubt as to the added diversification these active managers bring.
Below Nick looks at one such fund and highlights the massive divide.
Simon’s Substack Post
https://substack.com/home/post/p-194807618
Terry’s Investor letter
https://www.fundsmith.co.uk/media/lfhpxi1x/fundsmith-equity-fund-semi-annual-letter-to-shareholders-2026.pdf
For those who missed this week’s investment webinar on our Q2 performance, you can watch it here and view the Q2 performance tables here.
Valuations, Concentration and Liquidity.
In Tideway’s second-quarter webinar, presented at the beginning of the week, there was considerable discussion about market indices and how they are currently both highly valued and highly concentrated. The principal concern was that, at previous points in history when markets have reached similar levels, subsequent index returns have generally been poor.
What was not discussed on the webinar was the potential impact of passive investing on market functioning. It could be argued that, due to the dominance of passive strategies and the wider market’s increasing focus on short-term momentum rather than long-term fundamentals, price discovery is no longer as effective as it once was.
With Fundsmith’s semi-annual report acting as the catalyst, many investors, ourselves included, have revisited the passive investing debate, using Simon Evan Cook’s Substack post, ‘Victory for Passive! 22 thoughts and questions’ as the basis for our thinking. To date, we have not identified any arguments that have not already been articulated in that list.
Although we agree with almost everything presented, we do not believe that adopting momentum-based strategies, whose outcomes depend on factors beyond our control, is the appropriate response for our clients. Instead, we again look to Warren Buffett:
“The less prudence with which others conduct their affairs, the greater the prudence with which we should conduct our own affairs.”
Our response to these potential issues is to remain disciplined and continue allocating capital to managers who adhere to their investment philosophy and style, genuinely incorporate valuation into their decision-making, and maintain diversified portfolios. In the current environment, this typically requires managers to be benchmark agnostic.
Each manager is selected to fulfil a specific role within our portfolios. Managers deviating from their established discipline to pursue other areas of the market could create challenges from a portfolio construction perspective. We do not profess to know which investment style will outperform next and therefore allocate to managers with differing styles. When one style falls out of favour, we expect other parts of the portfolio to help offset that weakness. By contrast, allocating excessively to the dominant style, or allowing our managers’ approaches to converge towards the prevailing market trend, risks creating concentrated exposure to particular areas of the market. If everything rises together, it can also fall together.
We cannot expect all of our managers to perform well in every market environment.
Managers are often given too much credit when their style is in favour and too little when it is facing headwinds. Tideway avoided the temptation to sell value managers during the late 2010s and into 2021, when value strategies struggled against the backdrop of the FAANG stocks and quality-growth companies driving market returns.
The truth is likely somewhere in the middle. Terry Smith did not suddenly become a poor fund manager overnight.
Deep value:
One of the ways our portfolios have remained competitive during a challenging period for active managers has been through a meaningful allocation to deep value strategies, broadly defined as those investing in the cheapest 20% of the MSCI World Index based on valuation metrics. We currently allocate to two such strategies within our Core Equity portfolio, representing approximately 30% of the overall equity allocation.
A key feature of these strategies is the disciplined recycling of capital. Oversimplifying, this involves selling holdings that have performed well and reinvesting the proceeds into companies whose share prices have struggled, and which now offer more attractive valuations. Despite the common “falling knife” analogy, this approach has delivered strong results over time. This active portfolio rotation takes profits from successful stock selection while continually redeploying capital into more attractively priced opportunities.
An equally important benefit of this process is that it helps prevent portfolios from becoming increasingly exposed to yesterday’s winners. While managers will inevitably sell some holdings too early, particularly in today’s momentum-driven market, we believe that consistently adhering to a disciplined investment process and valuation framework is more likely to deliver superior long-term outcomes for clients than allowing successful positions to run simply in the hope of further gains.
Redwheel GIV versus iShares MSCI World:
We have used one of our deep value managers, Redwheel Global Intrinsic Value (GIV), to illustrate the role these strategies play in reducing overall portfolio valuations, increasing diversification and potentially providing better capital protection should overall market liquidity conditions reverse.
It should be noted that this is one of the more extreme examples within our Core Equity portfolio and is used for illustrative purposes. We have also regularly published equivalent data at the overall portfolio level, which
demonstrates the same (but less extreme) underlying characteristics.
Valuations:
- The bottom quintile of the MSCI World Index, where the team sources investment opportunities, continues to trade below its long-term average valuation.
- The valuation discount relative to growth stocks (the top quintile of the market) remains historically wide, with the valuation spread close to its widest level in the past 50 years.
- This is further illustrated by the three headline valuation metrics below, all of which are low in absolute terms and trade at significant discounts to the iShares MSCI World ETF.
Source: Morningstar, 09/07/2026, Holdings as at 31/05/2026 for Redwheel GIV, 07/07/2026 for iShares MSCI World ETF
Diversification:
Geography:
Geographically diversified, with a significant underweight to the US at approximately half the weighting of the iShares MSCI World ETF.
The US allocation is more closely aligned with its share of global GDP (approximately 26%) than with its weight in the MSCI World Index.
As a result, the strategy is not wholly dependent on continued strength in the US market to generate returns.
Sector:
The most notable positioning is the 28% relative underweight to the Technology sector, which is unsurprising given that many technology companies continue to trade on some of the highest valuations in the market.
Equally important is that, unlike in 2019, the cheaper end of the market is no longer dominated solely by Energy and Financials. Today, a low-valuation portfolio can be constructed across a broad range of sectors, including companies that were regarded as quality growth leaders only a few years ago.
Although Financials have been a significant contributor to performance in 2025, the manager has taken profits and now holds an underweight position. This disciplined approach helps keep the portfolio well positioned across a broader range of economic and market environments.
Source: Morningstar 09/07/2026, Holdings as at 31/05/2026
Style/ Market Capitalisation:
Morningstar’s well-known style map provides a useful visual representation of the manager’s investment approach. The blue marker sits firmly within the deep value area, reflecting the manager’s focus on attractively valued companies beyond the largest, most widely owned stocks. In contrast, the red marker is positioned much closer to the core of the market. The considerable distance between the two, together with the minimal overlap of the shaded areas, highlights the diversification benefits of combining contrasting investment styles within a portfolio.
Source: Morningstar 09/07/2026, Holdings as at 31/05/2026 (blue), 07/07/2026 (red)
Active Share:
- Although there are 27 overlapping holdings between the manager’s portfolio (of approximately 50 stocks) and the iShares MSCI World ETF, these positions represent just 1% of the index by weight, resulting in an active share of 99%.
- If persistent flows into passive funds, and out of active strategies, have inflated the valuations of the largest index constituents, a reversal in market liquidity could disproportionately affect those heavily owned stocks.
- Holding companies that are either outside the index or have only a small index weighting may provide greater resilience should selling pressure become concentrated in the largest benchmark constituents.
- Active share is an important measure that we monitor closely across all of our managers, as it provides a clear indication of how differentiated a portfolio is from indices.
Overall, this strategy demonstrates how we seek to balance valuations, diversification and liquidity risk within our portfolios. By investing in attractively valued companies that differ meaningfully from the broad market, we reduce concentration, maintain genuine active exposure and believe we are better positioned to navigate a wider range of market environments over the long term.
