Terry Smith, founder and chief executive of British investment management company Fundsmith, is often compared to Warren Buffett because he’s a fan of simple investment rules for success. The Oracle of Omaha also liked to keep things as simple as possible throughout his tenure as CEO of Berkshire Hathaway. He said Berkshire’s strategy is to buy wonderful businesses at a fair price. Smith’s three-step strategy is pretty similar:
- Buy good companies.
- Don’t overpay.
- Do nothing.
Like Buffett, Smith is also a fan of sharing market insights and wisdom in his shareholder letters, and his most recent letter comes with a stark warning. It’s a warning that might go against one of Buffett’s most popular recommendations, and suggests one trend is pushing the market toward “a major investment disaster.” Here’s what investors need to know.
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A big change in how we invest
Over the last 20 years or so, we’ve seen a huge rise in assets held by passive index funds. Low-cost index funds are seen as the simplest way to get started investing and ensure your fair share of the stock market’s returns.
Smith points out that assets held in passive funds overtook assets held in actively managed funds in 2023 and have continued to take share since. That trend has taken hold over time as passive funds have lower management costs; they’re offered in defined contribution plans like 401(k)s, which have replaced defined benefit plans (i.e., pensions); and retail investors have wisened up to the fact that active funds typically underperform after fees. Warren Buffett himself has championed index funds for years.
There are some notable impacts on the stock market as a result of this trend. First is an increase in market concentration. As capital moves from active portfolios to passive index funds, it can have a multiplying impact on some of the largest companies in an index like the S&P 500 or Nasdaq Composite. That’s because active investors may be forced to cover shorts (against the always-long passive investors) or adjust their portfolios to better align with the benchmark index they’re trying to beat (as Smith refers to it, career-preserving behavior).
For example, an investment manager might think it doesn’t make sense to buy Tesla shares at 387 times its trailing earnings (its current valuation), but with its weight in the index, it’s hard to bet against it. Any short-term outperformance by Tesla could lead to a fund manager’s ousting for poor relative performance. That’s regardless of whether omitting Tesla from a portfolio proves to be a smart move in the long run.
The increased concentration in the market points to the second, and more worrying issue for Smith. Stock prices are now more volatile and increasingly disconnected from their intrinsic value. With capital flowing into index funds, demand for any given stock is growing and increasingly inelastic. Passive funds have to buy shares to match the index. Likewise, the supply of shares is inelastic, as most large companies aim to maintain or even reduce their share count through buybacks.
As a result, a dollar flowing into a stock doesn’t necessarily indicate an increase in its intrinsic value. And with the knock-on effects of a dollar flowing into an index fund impacting active investor decisions, inflows can send share prices and valuations significantly higher.
As Smith writes in his 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.” He warns that the shift into index funds is “laying the foundations of a major investment disaster.” A shift in asset allocation from equities to bonds or cash will have a massive negative impact on stock valuations, especially for those with highly distorted values. That could lead to a severe drop in asset prices that could persist longer than past downturns.
Smith isn’t trying to predict the future with a great level of accuracy, though. “I have no clue how or when it will end except to say badly,” he said. But he also suggests investors can avoid the fate of the overall market distorted by index investors.
How to avoid investment disaster
There’s no way to know for sure just how the rising concentration of index fund investing is distorting the financial markets, if at all. But if you’re at all concerned about the potential impact the trend could have on volatility and valuation displacement, then it’s worth considering how to position your portfolio for a so-called “investment disaster.”
Smith favors his simple rules for investment success: 1. Buy good companies, 2. Don’t overpay, 3. Do nothing. Indeed, buying quality companies at a fair price is the most straightforward path to long-term returns, even if the growing amount of capital invested in passive funds doesn’t concern you.
The MSCI World Quality Index, which filters for companies with high returns on equity, stable earnings, and low debt, has historically outperformed the broader MSCI World Index. It also does so with less downside when the markets turn sour. That downside protection can be improved upon by focusing on quality companies trading at a good value.
The strategy won’t outperform the market every year, though. Smith volunteered the above theory as an explanation for Fundsmith’s relatively poor performance last year. Berkshire Hathaway underperformed the S&P 500 in roughly one-third of the years Warren Buffett operated the company. That’s roughly in line with how the Quality Index performs in any given year. But over the long run, you can produce strong returns with less volatility by focusing on Smith’s three rules. Quality stocks have delivered better total returns than the broader index in every 10-year period since the start of 1999.
