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If you ask professional fund selectors what the most challenging part of their job is, deciding what to do about an underperforming fund manager will come near the top of the list. DIY investors often face the same conundrum, which is unjustly made harder the more thorough you have been with your fund selection. If you do your homework properly, you will have high conviction in the manager, and that makes it harder to walk away.
This scenario might sound familiar if you’re invested in the Fundsmith Equity fund, which did extremely well for an extended period after launch but has since fallen on harder times. The fund has now underperformed the global stock market for the last five calendar years, and in a strongly rising market in 2025, the fund eked out a return of just 0.8%.
The fund manager Terry Smith is no shrinking violet, and his pugilistic defence of his investment strategy stands in stark contrast to the deeply apologetic tone struck by Nick Train, another star fund manager with a similar investment style, who is also going through a rough patch.
Are passive funds distorting the market?
Passive funds are in Smith’s sights. As he says in his latest letter to shareholders: “The increasing proportion of equities held by index funds are invested without any regard to the quality or valuation of the shares bought which produces dangerous distortions.”
In particular Smith is referring to the huge proportion of stock market returns which are coming from a small number of very big US technology companies. Index funds work by buying the biggest stocks in the market, and the contention is that large flows into passive vehicles are driving the share prices of these companies upwards without due regard for the quality of the businesses.
This analysis has a lot of merit and raises legitimate concerns about concentration risk and valuations in the US stock market. One could even describe Smith’s recent underperformance differently and say that rather than Fundsmith Equity falling behind the market, the market has actually pulled ahead of the fund. This comes to the same thing for investors of course, but it’s arguably a more illuminating way of looking at things.
Smith is far from alone in facing this predicament. AJ Bell’s latest Manager versus Machine report found that just 13% of active managers in the Global sector had outperformed a comparable index tracker over the last decade. That level of passive dominance suggests at the very least an environment which has been extremely favourable to index funds, and at worst, a market which is losing sense of economic fundamentals because so much money is being invested passively, purely on the basis of a company’s size.
Smith has never had the ‘Midas touch’
So where does this leave Fundsmith Equity investors? The fund has now fallen behind the MSCI World Index over 10 years. But it’s still ahead of the average fund in its sector and looking a bit further back to the launch of the fund in 2011, it’s still well ahead of both the global stock market and its peers.
At no point in this journey has Smith wielded some supernatural knack, the so-called ‘Midas touch’, which is so often attributed to successful fund managers, only to be ripped off when they falter. The reality is for a while Fundsmith’s returns were flattered by low interest rates, which proved a tailwind to Smith’s investment style. Now the shoe is on the other foot as his preference for quality stocks has struggled to beat other parts of the market.
What’s reassuring is that across these periods of performance, Smith has been consistent in applying a well-articulated investment strategy, similar to that employed by Warren Buffett. Recent performance has of course been disappointing, but investors should take reassurance from the fact Smith is sticking to his guns. His longer-term track record also puts some credit in the bank, and suggests along the way he has exercised skill, as well as experiencing his share of both favourable and adverse conditions.
How to approach an underperforming fund
It may be helpful to think about how you approach fund underperformance in terms of your broad approach to investing, rather than solely in relation to Fundsmith Equity. As an investor do you want to cut and run when a fund manager underperforms, or stick with them in the hope of a turnaround? Remember switching funds comes with costs attached, and jumping ship from one active fund to another doesn’t provide immunity from underperformance.
Bear in mind it’s not an all-or-nothing decision either. If you have less conviction in Fundsmith Equity, you can reflect that by selling some of your holding rather than all of it. Some investors may go the other way, believing underperformance to have created an attractive buying opportunity, perhaps re-allocating money to the fund from other areas which have done better.
Ultimately, if you’re an active fund investor, you have to accept the fallow with the fertile, and occasionally face tough judgement calls. This is a hard discipline, and may be another reason so many investors are turning to passive funds. Then again, if there is a rotation in market leadership away from big tech, active investors may yet have the last laugh.
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Laith Khalaf: Head of Investment Analysis
Laith Khalaf is AJ Bell's Head of Investment Analysis. He joined the company in 2020 and continues to explore the world of personal investing, providing research and analysis to both AJ Bell customers and the...
