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Investors with money in Fundsmith Equity and Scottish Mortgage should take note
Thursday 07 Jul 2022 Author: Laith Khalaf

Two of the most popular active funds of recent years, Fundsmith Equity (B41YBW7) and Scottish Mortgage (SMT), have had a terrible 2022 so far.

Fundsmith Equity has fallen in value by 18% and Scottish Mortgage is down by 44% in the space of just six months.



Investors might normally be spitting feathers at such performance, but these two funds have delivered exceptional returns for investors over many years, and so the managers have considerable credit in the bank.

All long periods of underperformance start with a short period of underperformance though, so how do you know when it’s time to ditch your active manager?

STEP ONE: BENCHMARK COMPARISON

The first thing to do is assess performance properly. Fund price movements up and down are clearly what ultimately matter most to investors, but if you’re evaluating an active manager, you need to set their performance in context, by comparing it to an appropriate benchmark.

Both Fundsmith Equity and Scottish Mortgage are global funds, so it makes sense to compare them to the performance of the global stock market, through a broad index like the MSCI World.

If you were assessing a UK fund you would probably use the FTSE All-Share as a comparator, or for a European fund it would be the FTSE World Europe ex-UK index. Most funds will provide a benchmark on their factsheet or in their prospectus if you need a point in the right direction.

The MSCI World index has fallen by 10% this year, so by this measure, Fundsmith Equity and Scottish Mortgage still fall short of the mark. But six months is a really short time over which to judge performance.

If you’re not prepared to accept six months of underperformance every now and then, you should probably opt for index tracker funds rather than active funds.

Looking at the examples of Fundsmith Equity and Scottish Mortgage over a longer period, things start to look better.

Over five years Fundsmith Equity has returned 62%, Scottish Mortgage has returned 92%, and the MSCI World index has returned 57% in sterling terms. In these cases, investors have got the outperformance which they come to expect from active funds.



STEP TWO: IS THE FUND’S STYLE IN OR OUT OF FAVOUR?

As an active fund investor, when your fund does underperform the relevant benchmark index, you also must give due consideration to the style of the manager.

Fundsmith Equity, for instance, runs a highly concentrated portfolio of only 30 companies. Performance can therefore deviate substantially from the market, for better or worse.

Fund manager Terry Smith also has a distinct preference for growth companies with robust finances which generate reliable profits.

These stocks have been in the ascendancy for most of the last 10 years, but more recently, higher interest rates and rising inflation have led to a reversal in fortunes.

Similar comments apply to Scottish Mortgage. Its managers run a high conviction portfolio of companies they believe are future leaders of the global economy. This has led to heavy exposure to the technology sector, which has seen a sell-off this year after an astonishingly strong bull run.

STEP THREE: WHY DID YOU ORIGINALLY INVEST?

If your fund is underperforming, ask yourself why you invested in the first place. Consider if anything has fundamentally changed that should lessen the original conviction you had in the fund manager.

In the case of both Fundsmith Equity and Scottish Mortgage, the managers haven’t changed their investment approach, it’s just the market has turned against their style of investing. The longer underperformance goes on, the more that will legitimately undermine investors’ confidence.

Markets can turn against a particular style of investing for long periods. As a rule of thumb, a year of underperformance should put a fund on the watchlist, three years should be a serious review when you decide to renew your vows or part ways, and after five years of underperformance, you need good reasons to keep the fund in your portfolio.

STEP FOUR: UNDERSTAND THE ROLE OF EACH FUND IN YOUR PORTFOLIO

A truly diversified portfolio of funds should have a mix of different fund manager styles, and at any one time some will be desperately unfashionable, and others will be flavour of the month. As time goes on, different fund styles will have their day in the sun.

Active fund investors have a choice when it comes to dealing with fund underperformance. Either you cut and run at the first sign of trouble,   or you sit and wait it out.

If you jump ship quickly, you might get out of some funds before a long downturn in performance, but equally you will miss out if the performance improves again.

Meanwhile, you also rack up trading costs and spend a lot of time and effort moving your portfolio around. If you move your money into another fund, who’s to say the one you choose is not about to endure a period of underperformance too.

If you choose the patient route, you avoid these issues. Sometimes you will hold a fund for longer than you would with perfect hindsight, but in a diversified portfolio, other funds should take up the slack. On balance it’s probably better to show a little faith in your chosen fund manager, even if occasionally it’s not rewarded.

DISCLAIMER: Editor Daniel Coatsworth has a personal investment in Fundsmith Equity.

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