Fundsmith star Terry Smith warns index funds are ‘laying foundations of a major investment disaster’
Star fund manager Terry Smith said the massive shift to passive funds could trigger a ‘major investment disaster’.
The warning comes after Fundsmith Equity posted another year of poor performance at its flagship fund, posting a return of just 0.8 per cent in 2025 compared to the MSCI World index’s gain of 12.8 per cent.
In his annual message, Smith said it could be disastrous if a growing number of investors turned to passive funds, which have become hugely popular in emerging markets because they offer a cheap and profitable alternative.
He emphasized that he was not seeking to ‘blame’ anyone or anything for the portfolio’s decline, but that there were three main factors behind it.
The fund manager said the continued dominance of a small pool of technology stocks, the Magnificent Seven, dominates the S&P 500 and index investors have no way to limit their exposure to technology trading.
Fundsmith manager Terry Smith has seen his investment style fall out of favor
He said: ‘In our view, owning them all would present too much portfolio risk; just like we can’t own all five beverage companies we have in our Investable Universe, even if we think the prospects for the sector are good.
‘Our fund is not a sectoral bet, it is a portfolio.’
Fundsmith Equity invests in only three of the seven tech giants: Alphabet, Meta and Microsoft.
He also lamented the shift from active funds like Smith’s, which track indexes and often rely on managers to pick and choose investments, to cheaper index funds.
He argued that passive funds risk disrupting markets through ‘momentum’ investments that drive valuations higher.
‘If companies or investors start making decisions based on rising share valuations that deviate too much from this assumption, the result will be disastrous.’
He added: ‘When we had the dotcom boom, AUM in index funds was less than 10 percent. The dominance of index funds now makes the rise of these big stocks a self-fulfilling prophecy.’
Smith’s £16bn flagship Fundsmith Equity Fund has attracted significant interest from investors since its launch in November 2010.
Adopting a Warren Buffett-style investment approach, the company has a concentrated portfolio of what Smith sees as high-quality global companies whose ‘advantages are hard to replicate’ and which provide high returns on capital employed.
Fundsmith has delivered an average annual return of 13.5 percent to investors since its launch, but its performance has been lagged as a small number of giant tech firms dominate the U.S. stock market and the global market respectively, generating high returns for several years.
Over the past five years, Fundsmith’s average annual return has been 5.7 percent, according to Morningstar figures. The MSCI World Index returned an average of 12.7 percent.
The proliferation and dominance of AI companies has led some to warn of an AI bubble.
Smith says AI can transform the way we work, but it can also create incremental cash flows that ensure the return on the massive amounts of capital they invest is adequate or better than adequate.
Otherwise, when the bubble bursts, investors will be proven wrong.
Smith said: ‘Even if we are right to diagnose this move into index funds as one of the reasons for our recent underperformance, and that it is laying the foundations for a major investment disaster, I have no idea how or when it will end, except to say badly.’
Terry Smith warns dominance in tech and AI stocks is hurting performance
Finally, Smith said recent dollar weakness, which has affected the sterling value of Fundsmith’s portfolio, has negatively impacted performance.
Smith said the fund ‘will not buy shares in companies just because they are large and dominate the index weightings and performance unless we are convinced they are good companies.’
He urged investors to look at longer-term performance, saying outperforming the market ‘is not something you should expect from our fund every year or reporting period.’
While Smith remains true to his investment strategy, he said ‘of course we will try to do better’.
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