Star fund manager Terry Smith has said the massive shift to passive funds could trigger a ‘major investment disaster’.
The warning came after another year of lacklustre performance at his flagship fund, with Fundsmith Equity posting a return of just 0.8 per cent in 2025, compared to the MSCI World index’s 12.8 per cent gain.
In his annual missive, Smith said growing numbers of investors moving into passive funds, which have made huge gains in popularity because they offer a cheap and profitable alternative in rising markets, could be disastrous.
He insisted that he was not ‘seeking to ‘blame’ anyone or anything’ for the portfolio’s downturn, but that there were three main drivers behind it.
The fund manager said the continued dominance of a small pool of tech stocks, namely the Magnificent Seven, had dominated the S&P 500 – and index investors have no way of limiting their exposure to the tech trade.
Fundsmith manager Terry Smith has seen his investment style fall out of favour
He said: ‘It would in our view represent too much of a portfolio risk to own them all, just as we would not own all five of the drinks companies we have in our Investible Universe even if we thought that prospects for the sector were good.
‘Our Fund is a portfolio not a sectoral bet.’
Fundsmith Equity invests in just three of the seven tech giants – Alphabet, Meta and Microsoft.
He also bemoaned the shift to index funds, which track indices and are typically cheaper than active funds like Smith’s, which rely on managers who pick and choose investments.
He argued that passive funds risk distorting markets through ‘momentum’ investing which pushes up valuations.
‘If companies or investors start making decisions which deviate much from that assumption based upon soaring share valuations the outcome will be disastrous.’
He added: ‘When we had the Dotcom boom the proportion of AUM which was in index funds was under 10 per cent. The dominance of index funds now makes the rise of these large stocks a self-fulfilling prophecy.’
Smith’s £16billion flagship Fundsmith Equity Fund has proved a huge hit with investors since it was launched in November 2010.
It adopts a Warren Buffet-style investment approach, holding a concentrated portfolio of what Smith considers high-quality global companies, whose ‘advantages are difficult to replicate’ and have high returns on capital employed.
Since launch, Fundsmith has delivered an average annual return of 13.5 per cent to investors but its performance has fallen behind as a small number of giant tech firms have come to dominate the US stock market and global market in turn, driving a number of years of bumper returns.
Over the past five-years, Fundsmith’s annual average return has been 5.7 per cent, according to Morningstar figures. The MSCI World Index has returned an average of 12.7 per cent.
The proliferation and dominance of AI companies have prompted some to warn of an AI bubble.
Smith says that AI may produce a transformation in the way we work ‘but also incremental cash flows such that the returns on the humongous amounts of capital they are investing will be adequate or better than adequate.’
Otherwise, investors will be proven wrong when the bubble bursts.
Smith said: ‘Even if we are right in diagnosing this move to index funds as one of the causes of our recent underperformance and it is laying the foundations of a major investment disaster, I have no clue how or when it will end except to say badly.’
Terry Smith warns that the dominance of tech and AI stocks are hurting performance
Finally, Smith said the dollar’s recent weakness, which affects the sterling value of Fundsmith’s portfolio, had dragged on performance.
Smith said the fund ‘won’t be buying shares in companies simply because they are large and dominate the index weightings and performance unless we become convinced that they are good businesses’.
He urged investors to look at longer-term performance and said outperforming the market ‘is not something you should expect from our Fund in every year or reporting period’.
While he will stick with the investment strategy, Smith said ‘we will of course seek to do it better.’
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