Star fund manager Terry Smith has admitted to feeling ‘a bit disappointed’ and apologised to any investors who felt short-changed as he hands over the day-to-day running of his underperforming Fundsmith Emerging Equities (FEET) investment trust after five years at the helm.
Smith is handing over the reins to Michael O’Brien and Sandip Patodia, who joined Fundsmith ahead of the trust’s launch in 2014, and will oversee them as Fundsmith chief investment officer (CIO).
Nearly five years after the trust’s launch, its shares are up just 24%, lagging the emerging markets index and most other investment trusts focused on developing economies.
It’s a far cry from the huge success Smith has enjoyed in running his Fundsmith Equity fund, now the UK’s largest at £17 billion and up 342% since launch in November 2010, topping the Investment Association’s Global sector by a huge margin.
Time for change
Speaking to Citywire, Smith said the time had come to make changes to how the trust was run.
‘The important thing when you’ve gone through four or five years and it’s looked like that is to say, “OK, it didn’t quite work as we thought it was going to work, is there something we should be doing differently?”,’ he said.
Smith apologised to any investors who felt short-changed by his move away from the coalface, acknowledged by a cut to the annual management charge, from 1.25% to 1%.
‘Sorry about that. It’s very important to say that, obviously,’ he said, adding that the scale of his personal investment in the trust showed he was ‘continuing to put my money where my mouth is’.
‘I’ve got several million pounds invested in this and I’ve continued to invest in it whenever the stock has been available.’
Smith said remaining involved with the trust as CIO, but handing over day-to-day running, was an acknowledgement both of the trust’s performance difficulties and the competing claims on his time.
‘Every human being, including me, has a limit to the amount of things they can focus on,’ he said. ‘Having people who are actually full time working on the trust as portfolio managers is more of a necessity than I thought it was.’
'Not running away'
While Smith is taking a step back, he said he was ‘not running away from it or anything like that’.
‘I still think the investment thesis is a decent thesis. It needs better execution maybe than we’ve had so far,’ he said, arguing that despite the trust’s performance difficulties, it could still come good in explosive fashion.
‘In performance terms it’s still a very rescuable proposition,’ he said. ‘Performance arrives like ketchup out of a new ketchup bottle. If and when we do make this work, my guess on the nature of these markets and these stocks is it won’t go up one or two per cent a month.’
Key to delivering a turnaround in performance will be addressing the problems Smith has faced in translating the success of his investment approach with Fundsmith Equity to emerging markets.
Smith characterises his approach as ‘buy good companies, don’t overpay, do nothing’. But he admits this focus on quality companies, of which a high return on capital employed is a major factor, and minimal trading has been harder to implement in developing economies.
The last part of that mantra has been the most difficult to follow. Smith’s emphasis on minimal trading has meant portfolio turnover in his flagship fund has never risen above 14%. On the trust it has been much higher. Turnover stood at 67% in 2015, admittedly when the portfolio was still being invested, falling to 38% in 2016, 34% in 2017 and 19% last year.
‘It’s coming the right way but it’s taken an awfully long time to come down,’ Smith said. He argued that emerging markets threw up much more ‘incident risk’, where the outlook for a company could change to such a degree that the only response was to sell it.
Economics bite in emerging markets
And while Smith is happy to ignore macroeconomics in the running of his flagship fund, he hasn’t been afforded that luxury by emerging markets.
‘When you get into emerging markets, every time you make an investment decision you are, I’m afraid, making a macro call,’ he said.
‘As much as you are buying the company, you are buying the company in India, which exposes you to economic as well as currency and political risk.’
The impact of investors piling into emerging markets through exchange-traded funds (ETFs) has also weighed on the trust’s performance, he said.
‘Since we launched, more than 100% of the flows going into emerging markets have gone into ETFs. That means it’s market weighted, going into an index. We don’t own any of the top 10 companies in the index and we don’t own very much in China which is the biggest country in the index,’ Smith said.
‘Whereas standing out different to the index, which we do on the main fund, is a very good thing if you’re trying to get differential performance, it can be problematic for very long periods of time if the index you are standing apart from is the recipient of more than 100% of the inflows.’
'Fresh look' from new managers
Smith said a turnaround in performance could come from new managers O’Brien and Patodia taking a ‘fresh look’ at the sort of companies the trust invests in.
While they won’t deviate from the fundamentals of the Fundsmith approach, Smith said they may revisit some of the big companies that are among the top holdings in the MSCI Emerging Markets index the trust has previously shunned.
‘The biggest single thing the FEET portfolio managers will do is to go and have a look and dust the files off all the things we’ve looked at – not just the top 10 but the biggest stocks in the index, and see whether there are any there that we should own, that you can fit through the filters that we’ve got,’ he said.
The focus of the trust, which to date has been squarely on the rise of the emerging markets consumer, could also evolve.
‘Are there any companies which are headquartered and operate in emerging markets but which have a big business exporting into the developed world from which they have an advantage? That’s not something we’ve done historically and I think they are going to take a fresh look at that,’ Smith said.
‘At the moment we’ve not invested for example in any of the Indian software companies even though they are big software companies, they are the biggest offshore software companies in the world and they clearly have an advantage from being in India even though the majority of their sales are into the developed world.’
The new management approach for the trust echoes that employed on Smithson, run by Simon Barnard and Will Morgan with Smith overseeing them.
‘We launched Smithson last October and it’s been very successful so far and I just think it the portfolio management works better,’ said Smith.
‘It works an awful lot better having somebody else being the day-to-day manager and having me as the point of referral as Fundsmith’s CIO when they go, “I’m worried about this” or “I’m going to sell this” or “I’m going to buy that”.