Terry Smith on Index Investing

Active vs Passive Fund Share of US Equity Fund Assets Source: Research Affiliates, Data as at 31st Dec 2024 The financial services industry sometimes does not aid understanding with the labels it employs. Index funds and index ETFs are often labelled ‘passives’ in contrast with ‘active’ funds, like Fundsmith Stewardship Fund, which have a fund manager making investment decisions. The ‘passives’ mostly track the index they invest in by holding the stocks in proportion to their market value. Far from being passive in any normally accepted sense of the word, this makes them a momentum strategy. A momentum investment strategy is one in which the investor buys stocks which are performing strongly. If you redeem money from an active fund like Fundsmith and invest it in an S&P 500 Index tracker fund your new fund will buy the index stocks in proportion to their market value. Currently about 7% of it will go into Nvidia which we do not own. About 35% will go into the Magnificent Seven of which we own only three stocks — Alphabet, Meta and Microsoft. This gives added momentum to those stocks we do not own which are a major part of the index. John Bogle, the pioneer of index investing who founded Vanguard, the index fund manager, was asked at the 2017 Berkshire Hathaway annual meeting if there was a level of assets in index funds which would distort markets and he agreed that there was, although he had no method of determining that level. We may already have reached it.markets

hypothesis’. You may not have heard of this as it is not the sort of thing to take for a read on a long flight. However, it has some startling revelations which are relevant to the current market. It starts with the seemingly uncontroversial assertion that $1 (or $1m or $1bn) switched between either stocks or bonds (or any other switch) does not affect the intrinsic value of either. If you redeem funds from an active fund like Fundsmith to place them in an index fund it does not alter the valuation of the stocks we have to sell to fund the redemption or the stocks that the index fund buys. However, the NBER paper shows that in reality such a switch has a multiplier effect of anything from 3:1 to 8:1, an average of about 5.5:1. The inflow from such switches pushes up the value of the stocks purchased by an average of five times the amount invested. To say this flies in the face of fundamental investment theory would be a masterly understatement. The NBER paper attributes this to the inelasticity of demand and supply for equities. Over 50% of equities are in index funds which have no discretion over what they buy. Moreover, some portion of the so-called active funds which are left are managed in a way that makes them unlikely to bet against what is happening in the index. Apart from any mandate restrictions, fund managers have long realised the career preserving nature of so-called closet indexation in which they do not stray far from the index weightings.

We are not going to do either. If you want an index fund you can buy one with much lower costs than we or any other active investment manager apply. Nor are we momentum investors and there are better exponents of this investment strategy than us. I would just offer one note of caution if you are thinking of taking this approach. Good momentum investors in my experience buy shares which are going up and sell them when they start going down. They do not convince themselves, for example, that because they have bought Nvidia shares when they are going up, they know what is going to happen with AI or GPUs.

In late 2023 passive investment via index funds exceeded the amount of assets held in active funds for the first time. They are now more than half of Assets Under Management (‘AUM’). However, during the Dotcom boom only about 10% of AUM was in passive funds. As ever we do not always aid understanding with the labels which we sometimes use in investment. Index funds are not truly a passive strategy. There may be no fund manager taking investment decisions, but such index investing is in fact a momentum strategy. The vast majority of index funds are market capitalisation weighted, like the indices on which they are based. The size of holdings in companies in the index fund is based upon their market value compared with the market value of the index. So when there are inflows to index funds the largest portion goes to the largest companies, and vice versa when there are outflows. The result is that as money flows out of active funds and into index funds, as it has been doing, it drives the performance of the largest companies which are companies whose shares have already performed well which is how they came to be the largest companies by market value. This is a self-reinforcing feedback loop which will operate until it doesn’t.

If you had invested $100 in the Vanguard Long US Government Bond Index Fund (Ticker: VBLAX, ‘Bond Fund’) in June 2020, at the trough in yields on US Treasury bonds, your total income over the next 10 years would be a mere $7 i.e. you would receive 70 cents per annum in income. You would have had to invest a lot of dollars to get an income you could live on. Had you invested in October 2023, which may represent the high point in this economic cycle for bond yields, your total income over the life of the investment will be $47.50. Quite a change. This illustrates two points. One is that you would have lost a lot of money had you bought the Bond Fund in 2020 and had still been holding it in October 2023. The Bond Fund’s net asset value, at which it trades, declined from a peak of $17.71 in June 2020 to a low of $9.19 in October 2023, a fall of 48%. This puts the losses from investing in high quality equities over this period into perspective. Better to be in equities than long bonds when interest rates rise sharply. The other point it illustrates is that bonds have been offering an alluring alternative to equities for many investors.close

It is worth pointing out that the performance of the Fund tabled at the beginning of this letter is after charging all fees which should surely be the main focus. This year I thought I would use the opportunity afforded by this letter to talk about so- called activism and takeovers since we have seen a lot of events in these areas in the past year which have affected the companies we own and follow. Investment is a world in which words get used in confusing ways. Take the words active and activism. Active investors are the opposite of passive investors who simply seek to replicate the performance of an index. At Fundsmith we are active investors— our Fund will only own a maximum of 30 shares (it owned 27 as at 31st December 2017) and we limit it to a few sectors which have the characteristics we seek: consumer staples, some consumer discretionary products, healthcare and technology being the main sectors. So we are far removed from a passive investor. However, we change our portfolio positions very infrequently which I suppose makes us an inactive active investor. You can see why people are often confused. Activists are a different animal. They seek to benefit by causing change in corporations they invest in. Activists are usually active managers but some of them are passive (I’m not making this up) as they seek to improve the returns on their index fund by agitating for change where they feel it is necessary. So I suppose they could be described as passive activists.

There is nothing in the performance of Domino’s which causes us the slightest concern about this but there is plenty wrong with the banking system which will be required to provide the refinancing. As a result we hope to have the opportunity to become investors in Domino’s again. The net result this was that the Total Expense Ratio of the Fund was 1.2%. We hope to reduce that in future. The historic dividend yield on the Fund at year end was 2.4%. This dividend was covered 2.6 times by earnings. There is only one stock in the Fund that does not currently pay a dividend. This is significant: it is becoming clear that dividends are likely to provide a more significant portion of the total return on equities in the future than they did in the equity bull markets of 1982-2000 and 2003-07. The current yield on the Fund may not fully reflect its dividend paying capabilities as some of the companies also utilise share buybacks. During the course of the year we published some research on share buybacks (“Share Buybacks-Friend or Foe?” April 2011-available on the Fundsmith website) in which we concluded that buybacks were rarely accompanied by any reasoned justification; that they had become almost universally regarded as a good thing and contributing to shareholder value irrespective of the price paid or the valuation implied, which simply cannot be true; and in many cases their timing was poor.

continue growing to the point where they had replaced most active funds and still leave Fundsmith with an insignificant share of the remaining sector, so they are unlikely to affect us; and 2) I have long and publically maintained that the best equity investment for most investors most of the time is an index fund because of its low cost and outperformance of most active fund managers. In an effort to be clear, my criticisms of ETFs are: 1. ETFs are almost certainly being mis-sold. My straw poll of investment professionals suggests that many investors think that ETFs are simply index funds. Many are not. Synthetic ETFs do not hold underlying securities of the sector or market they are supposed to replicate. Inverse ETFs can lose money even when the market sector they track has gone down, and leveraged long ETFs can lose money when their market or sector has gone up. None of these is consistent with the performance of a simple index fund. 2. Synthetic ETFs are of particular concern. If a fund which is described by the words synthetic, derivative, swap and counterparty does not cause you obvious concerns, I suggest you may need to study the events of the credit crisis of the past four years more carefully. 3. Because ETFs are tradable on markets unlike mutual funds, traders can sell them short.

This seems counter intuitive: how does a low cost product become a major profit contributor? The answer of course is that synthetic ETFs in particular provide banks with innumerable ways to “clip the ticket” of the ETF. The fees paid by the ETF investor are a very small portion of the total revenues which operating the ETF provides. They also deal for the ETF, provide the swap agreements by which it holds its synthetic positions (I wonder who works out whether the bank is providing them a fair price?), and maybe earn leverage, prime brokerage, custodian and registrar fees. The banks also deal for the hedge funds and traders who want to trade the ETF. At about this point, I began to realise why my critique of ETFs had caused so much fury. My advice on this matter is simple. A broadly-based index fund is often the best investment you can make in the equity markets.buy

precisely that, an index fund, not an ETF. The only difference between a physical ETF (which frankly is the only sort you should contemplate unless you like the risk of synthetic derivative swaps with counterparty risk) and an index fund is that the ETF is traded on the market as the term “Exchange Traded” implies. Every piece of research I have encountered and all my experience shows that frequent dealing is the enemy of a good investment performance. So why buy an ETF rather than an index fund? You can deal daily in most index funds. The only people who want to deal more frequently than daily are hedge funds, high frequency traders, algorithmic traders and idiots (these terms are not mutually exclusive). Why join them? If you don’t want active management, and mostly you shouldn’t, buy an index fund. During 2010 Fundsmith also launched a SICAV and a US LLP. Neither of these affects your investment in The Fundsmith Equity Fund but I feel that you should be informed about this and it affords me an opportunity to raise another subject-currencies. The SICAV is denominated in Euros and based in Luxembourg. It is a so-called “feeder” fund-the only assets it holds are units in The Fundsmith Equity Fund. The US LLP is a Delaware partnership denominated in US dollars which is invested with exactly the same strategy as The Fundsmith Equity Fund but it cannot be run as a feeder fund. We launched these two funds in response to investor demand.

This year’s rant is a warning about the misunderstanding and misuse of Exchange Traded Funds (“ETFs”). I think this is relevant as The Fundsmith Equity Fund launch was somewhat against the tide of events as we launched an active equity fund at the end of a decade in which a) equities have performed badly; and b) the average active fund manager has again underperformed the index and so made a bad performance by the asset class worse. Faced with this failure of active management, it is hardly surprising that investors have turned their backs on active management and headed for lower cost, passive alternatives. As a result, the rise of ETFs has been a major feature of the investment landscape in recent years. By the third quarter of 2010, there were 2,379 ETFs with 5,204 listings on 45 exchanges managing $1,181.3bn of assets. So what’s the problem? I suspect that the average investor regards all ETFs as just another form of index fund, and indeed many of them are. But many aren’t and therein lies the potential for misunderstanding. Or worse. Some ETFs do indeed replicate the performance of an index by purchasing a weighted package of all or most of its constituent securities. But many so-called synthetic ETFs do not do so and instead use so-called swap agreements with counterparties who agree to provide a monetary return which matches the underlying asset class or the index the ETF is seeking to track.