Is Terry Smith right to blame index funds for his struggles?
- Robin Powell
- 18 minutes ago
- 6 min read
Terry Smith blames index funds for five consecutive years of underperformance at Fundsmith. It's a compelling narrative — but when you test it against the evidence, it falls apart.
You've seen this story before. A celebrated fund manager hits a rough patch. The explanations start flowing. Market conditions. Structural changes. Forces beyond anyone's control.
Smith isn't some marginal figure. He built one of Britain's most successful funds, earned a devoted following, and made a fortune doing it. When he warns that passive investing is creating "dangerous distortions" and laying "the foundations of a major investment disaster," the claim deserves scrutiny. Not dismissal. Not acceptance. Scrutiny.
Plenty of people have already voted with their feet. In 2024, UK investors pulled roughly £1 billion from Fundsmith while pouring a record £28 billion into index trackers. But is that the right call?
Smith's claim is testable. International markets offer a natural experiment. Factor analysis reveals what's actually driving his returns. And when you run these tests, his diagnosis doesn't hold up.
The excuse that never dies
Active managers have blamed index funds for their struggles since index funds existed. Smith's argument is the latest version of a claim that's been failing for 50 years.
His mechanism goes like this: when investors switch from active funds to trackers, those trackers buy stocks in proportion to market cap. Money flows mechanically into whatever's already large. The Magnificent Seven get bigger. Managers who don't own them in full weightings fall behind. "It was difficult to even perform in line with the index in recent years,"
In his latest annual letter to investors Smith writes, "if you did not own most of these stocks in their market weightings, and we would not do so."
There's a logic to it. Index funds do buy without regard to valuation.
But fund managers have made some version of this argument since John Bogle launched the first retail index fund in 1976. As FT Adviser put it: "Variants of these excuses have been made by stockpickers ever since the first index fund was born in the 1970s." The specific mechanism changes — sometimes it's impaired price discovery, sometimes momentum effects, sometimes governance failures from passive ownership. The message stays constant: the game is rigged against us.
Smith has been laying the groundwork for years. His 2022 letter warned investors not to expect outperformance "in every reporting period." His 2023 letter said outperforming was "more than usually challenging." His 2024 letter: "more than usually challenging once again." His 2025 letter: "challenging once again."
If passive investing has been destroying active management for five decades, why is the industry still collecting fees?
If index funds are the problem, why aren't international markets affected?
Smith's claim is testable. It fails the simplest test you can run.
If passive investing distorts markets by mechanically inflating large-cap stocks, the effect should appear wherever indexing dominates. New York, Tokyo, Frankfurt — shouldn't matter. The mechanism Smith describes would work the same way in any market where index funds hold a significant share of assets.
So look at international markets. According to Dimensional Fund Advisors, about 57% of non-US equity assets under management sit in index funds. That's not far behind the US figure of 64%. If Smith's theory holds, large-cap international stocks should show the same "dangerous distortions" he sees in American markets.
But they don't. The MSCI World ex USA Index returned 8.41% over the past decade. Its average return since 1970? 8.67%. Dead-on with historical norms.
International large caps aren't behaving strangely. They're doing exactly what fifty years of data would predict. The supposed distortion appears only in the market where Smith happens to be struggling.
This doesn't prove indexing has zero impact on prices. Research shows index reconstitutions can move stocks being added or deleted. But the large-cap comparison suggests index flows aren't the primary driver of the S&P 500's recent strength — and they can't explain why one fund manager keeps falling behind.
2025 was supposed to be different
As I explained in a recent article in The Times, last year offered exactly the conditions active managers say they need. Wide dispersion. Clear winners and losers. A genuine stockpicker's market.
The S&P 500 returned 17.9%, but individual stocks told wildly different stories. The ten best performers gained at least 108%. The ten worst fell by 40% or more. In the UK, almost half of FTSE 100 constituents rose 20% or more — Rolls-Royce doubled, Babcock soared 150% — while eight stocks dropped at least 20%.
This is fertile ground for anyone who claims they can spot winners and avoid losers.
So what happened? Smith's Fundsmith Equity returned 0.8%. Cash returned 4.2%. The MSCI World Index delivered 12.8%. Among the 562 funds in the IA Global sector, Fundsmith ranked 504th.
One bad year proves nothing. Fund managers have cold streaks. But this was Smith's fifth consecutive year of trailing his benchmark — in conditions tailor-made for active management to shine.
If stockpickers can't outperform when dispersion is this high, when can they?
What's actually driving Smith's returns
There's a simpler explanation for Smith's struggles. It has nothing to do with index funds.
In 2019, researchers at AQR published an analysis of Smith's track record alongside Neil Woodford's. They wanted to understand what drove these "superstar" managers' returns. The findings were striking: when they controlled for systematic factor exposures — particularly the quality factor — nearly half of Smith's apparent alpha disappeared.
Smith wasn't picking brilliant stocks. He was fishing in the right pond. His portfolio tilts heavily toward high-quality companies: strong balance sheets, consistent earnings, high returns on capital. When quality stocks outperform, Smith outperforms. When they don't, he doesn't.
Lately, they haven't. MSCI World Quality lagged the broad MSCI World Index by about 0.3 percentage points in 2024. In 2025, the gap widened to nearly 5 percentage points. That's not a market warped by passive flows. That's a factor going through a rough patch — which happens to all factors eventually.
And eventually, quality will have its day again. Factors cycle. The quality premium has been documented across decades and geographies. When it returns, investors who want exposure have a choice.
They can pay Fundsmith's 1.04% annual fee and hope Smith picks the right quality stocks. Or they can buy something like the iShares Edge MSCI World Quality Factor UCITS ETF, which tracks the MSCI World Sector Neutral Quality Index for a fraction of the cost. Same factor exposure. No manager risk. No star-worship required.
AQR credited both Smith and Woodford with identifying profitable factors early and sticking with them through volatility. That's genuinely hard. But the Woodford comparison should give anyone pause. AQR praised both men as superstars in May 2019. Four months later, Woodford's fund suspended trading.
The verdict from fund flows
While Smith blames index funds, his own investors have been quietly moving their money into them.
Fundsmith saw over £1 billion in redemptions during 2024. The outflows continued into 2025, with only a brief reversal in September interrupting the exodus.
Active UK funds collectively lost £29 billion in 2024. Over three years, the total reaches roughly £105 billion. Meanwhile, UK index trackers pulled in a record £28 billion last year.
Investors aren't reading academic papers on factor attribution. They're looking at returns, looking at fees, and drawing conclusions. Smith cautions against becoming "obsessed with charges to such an extent that you lose focus on the performance of funds." When your fund returns 0.8% while charging 1.04%, that argument lands awkwardly.
How to test any manager's excuses
Smith's argument follows a familiar pattern. It's worth having a framework for evaluating these claims — because they'll keep coming.
When a manager blames market mechanics, ask: does the effect appear in comparable markets? If index funds distort US equities, they should distort international equities too. They don't.
When past performance is cited as proof of skill, ask: what factors drove those returns, and how are those factors performing now? Much of what looks like stock-picking genius is often systematic exposure available more cheaply elsewhere.
When fees are dismissed as secondary, ask: what's the realistic probability this manager will outperform after costs over a meaningful time horizon? The long-term data aren't encouraging.
These questions won't settle every debate. But they shift the conversation from narrative to evidence.
Getting the diagnosis right matters because the treatment depends on it.
Smith has diagnosed his fund's struggles as an environmental condition — index fund dominance warping prices and making life impossible for skilled stockpickers. It's a compelling story. It shifts responsibility from manager to market structure. And it's been told, in various forms, for half a century.
The tests don't support it. International markets with similar passive penetration show no distortion. 2025's high-dispersion conditions should have favoured active management, yet most managers still lagged. Factor analysis reveals that much of Smith's historical success came from systematic quality exposure — exposure that's been struggling lately, as factors sometimes do.
None of this means Smith lacks intelligence or conviction. It means his struggles have a simpler, better-evidenced explanation than the one he's offering.
The fund industry will always produce new explanations for why this time is different. The job isn't to accept or reject them reflexively. It's to test them.
In this case, the result is clear.
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