Is Fundsmith's size detrimental?

The size of a fund is important if it invests in areas such as smaller companies because if it is too large it cannot invest in all the available options. Taking a reasonable stake relative to the fund's size could mean owning a large proportion of one company, which could make it harder to dispose of a holding in it or buy more in the proportion it wants. And if a fund’s holding in a UK-listed company exceeds 30 per cent of its voting shares, it would have to make a takeover offer.

Fund size is less of an issue for global equities funds such as Fundsmith Equity that invest in very large global companies, as even if they put a meaningful percentage of their assets into one of these, they would still only hold a fraction of such a company’s overall market cap. But even with these types of funds you cannot ignore size. 

Adrian Lowcock, head of personal investing at Willis Owen, suggests that size could become an issue when a global large-cap equities fund has assets worth £10bn or greater. And Rob Morgan, pensions and investments analyst at Charles Stanley, believes that “over £15bn puts a fund in ‘super tanker’ territory, and demands greater scrutiny on the issue of size and scalability”.

Being very large can mean that a fund’s manager has a smaller universe of companies to choose from, which could potentially be detrimental to its relative performance if the range of available options are not doing well or lagging companies smaller than the fund invests in.

If a holding is not easy to buy and sell it could limit a fund’s manager to move in and out of it when they need to. Liquidity is also a concern with open-ended funds because if many investors want to withdraw their money from the fund it needs to be able to liquidate enough of its holdings quickly enough to meet the redemptions. This has been a problem with very illiquid assets such as property, although has been not a problem with large, global companies listed on a stock exchange because there is a great deal of trading in their shares.

But Mr Lowcock says: “Liquidity even in the most liquid stocks can dry up if investors change their minds about the opportunity. And if everyone rushes for the exit, a fund in this space would [also be] likely to see outflows and be a forced seller of companies. Although liquidity is unlikely to disappear in global giants it could shrink enough in the short term to impact these companies’ share prices and increase volatility.”

Being large is also not always a guarantee that a company has many shares in circulation.

“It is key that the companies [very large funds invest in] are large themselves and have a decent free float,” says Ryan Lightfoot-Brown senior research analyst at FundCalibre. “If a stock has a large market cap but lots of it is held by investors who don’t trade, such as founding families, then [size] can be deceiving.”

The fund’s investment strategy is also important.

“A ‘buy and hold’ philosophy, which means rarely trading in and out of holdings, is better [with a very large fund] than a high turnover approach,” says Mr Morgan. “And having a pragmatic, flexible mandate is preferable to a very prescriptive and discerning approach that cuts down [its investment] universe [even more]. Ultimately, you want a manager to have enough investment options to populate their fund via their style and approach without having to compromise.”

It is also important to ensure that large global equities funds focus very large, liquid companies out of choice rather than necessity.

“Make sure the fund is not a [former] multi-cap fund whose performance has come from small and mid-caps when it was growing, but now can't find any alpha as it has hit it's natural capacity [for investing in these],” advises Mr Lightfoot-Brown.

He adds that it’s also worth looking at how much of a stock is owned by a fund and overall by the asset management group that runs the fund.

Big benefits

Some fund running costs are fixed so the bigger a fund becomes, proportionately, the smaller these costs become as they are spread over a larger investor base. But for investors to benefit this also relies on the asset manager that runs the fund passing on the cost reduction via lower fees. “An encouraging number of funds have lowered their fees when they got to a considerable size in recent years,” says Mr Lightfoot-Brown. “Baillie Gifford is the standout house in this regard. But there are still many funds that don’t pass on the savings.”

Taking larger stakes in a company can mean that a fund manager has greater access to and is able to exert influence on a company, for example, on issues such as its dividend distributions and strategic plans. “One notable example is Stuart Rhodes, manager of M&G Global Dividend (GB00B39R2R32),who used his large shareholding in Methanex (CAN:MX) to encourage better capital discipline,” says Mr Lightfoot-Brown.

The ability to influence is particularly relevant for funds that take environmental, social and governance (ESG) issues into consideration, and look to exert pressure on companies to change their policies or behaviour. However, even if a fund is large but only owns a small proportion of a very large company it cannot have great influence alone. But it can be effective if a number of funds run by an asset management company have investments in a company and in aggregate own a significant stake in it.

<box out> Fundsmith Equity's long-term buy-and-hold approach wins out

The largest global equities fund available to private investors in the UK is Fundsmith Equity (GB00B41YBW71), which had assets worth £21.2bn as of 30 October. However, its investment policy is to hold very large global companies and the average market capitalisation of the 30 stocks it currently holds is over £130bn, so despite its size it only holds small proportions of them. 

 “Because of the size of the companies the fund invests in it is not yet at risk of being too large,” says Mr Lowcock. “And although it is concentrated, the [size of the fund's] largest holding Microsoft (US:MSFT) [is worth] about £1.4bn – less than 1 per cent of it.”

Microsoft had a market cap of $1.53 trillion (£1.19 trillion) as of 2 November and Fundsmith Equity does not feature among its 10 largest shareholders.

Running a concentrated portfolio means that the fund does not necessarily need a large investment universe. And its manager Terry Smith generally takes a buy-and-hold approach so does not need to do much trading.

“One of the worries was that, in a sell-off, a fund like this would struggle, but it managed to survive in the liquidity vacuum that was the Covid-19 sell-off, which was one of [this fund’s] biggest tests to date,” says Mr Lightfoot-Brown. “Mr Smith only buys mega-caps with very established businesses and positions.”

Fundsmith says that this fund’s seven day liquidity figure is 62 per cent and had no problem meeting redemptions worth £342m in April. The company also says that Fundsmith Equity Fund could maintain a liquid position even it was nearly £40bn in size.

Laith Khalaf, financial analyst at AJ Bell, points out that this fund hasn’t yet faced a sustained period of underperformance and outflows. But he adds that the fund’s very strong performance to date means investors might stick with it through a poor period of performance.

Fundsmith Equity has been criticised for not having lower charges because these vary between 0.95 per cent and 1.55 per cent, depending which share class you invest in. Many active funds focused on mainstream listed equities have ones of below 0.9 per cent. For example, Lindsell Train Global Equity has ongoing charges of 0.5 per cent or 0.65 per cent, depending on which share class you buy.

“Terry Smith makes the argument that his long-term buy-and-hold approach reduces portfolio turnover and therefore lowers the overall cost of ownership,” says Mr Khalaf. “But there are other active managers who take a similar long-term approach and charge less. Notably Scottish Mortgage Investment Trust (SMT) has delivered higher returns than Fundsmith Equity and has an ongoing charge of just 0.36 per cent.”

Fundsmith says that although the fund’s ongoing charge is higher than that of some other global equities funds, because they don’t trade its holdings frequently trading costs are lower. They only spent 0.005 per cent of the fund's average value in 2019 on trades, excluding redemptions and subscriptions. Trading costs are not included in a fund's ongoing charge but still eat into the ultimate return it makes for its investors. And Fundsmith argues that the fund's strong performance justifies its fees.

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How to hold large funds

Besides Fundsmith Equity, other large global equities funds include Morgan Stanley Global Brands (LU0119620176) and Lindsell Train Global Equity (IE00BJSPMJ28), which also tend to invest in mega-caps for the long term. See Investors Chronicle of 23 October for our interview with this fund's manager, Nick Train, or listen to it here.

“These have been big for some time and done well this year again,” says Mr Lightfoot-Brown. “[Size] is something we keep an eye on but for now they look ok. These funds haven't got to such a size without being able to manage these issues. [But it is important to look] at the liquidity profile and free float [of the companies they hold], and understand whether the managers have a plan for and are on top of liquidity concerns.”

Rather than totally avoid very large but successful global equities funds, analysts suggest ensuring that you do not have too great a percentage of your own money in one of these – especially if it is concentrated. Mr Lowcock suggests not putting more than 10 per cent of your portfolio into one fund so if one of these accounts for more it could be worth trimming the exposure. 

“It pays to have a spread of managers so that if one starts to go through a sticky patch, the other [funds] can keep your portfolio on the right track,” adds Mr Khalaf.

But he thinks that size could become an issue further down the line. “You should watch [other things including] performance, and keep an eye on size,” says Mr Khalaf. “Because in say, five years' time, how big will Fundsmith Equity and companies such as Apple (US:AAPL) be?

Smaller options

If you prefer to invest in a smaller active global equities fund, several analysts suggest LF Blue Whale Growth (GB00BD6PG563), which had assets worth £563m as of 30 October. Like Fundsmith Equity and Lindsell Train Global Equity, it looks to invest in large, good quality companies, and typically only has between 25 and 35 holdings. The fund only launched in 2017, but so far its performance has been very strong and its lead manager, Stephen Yiu, has 17 years' investment experience.

Mr Khalaf suggests TB Evenlode Global Income (GB00BF1QNC48), which had assets of £858m at the end of September. “The Evenlode team seek companies with strong finances that offer predictable earnings growth and the ability to pay a growing dividend,” he says. “The fund is concentrated with 30 to 40 stocks, which its managers want to hold for the long term.”

This fund only launched in 2017, but its lead manager, Ben Peters, is also co-manager of UK equity income fund, TB Evenlode Income (GB00BD0B7D55), which has a much longer and highly successful record.

For an active ethical alternative, Mr Morgan suggests Stewart Investors Worldwide Sustainability (GB00B7W30613), which had assets worth £550.6m at the end of September. Its managers invest in companies they think can benefit from and contribute to the sustainable development of the countries in which they operate.

Mr Khalaf also suggests holding complimentary funds alongside large mainstream funds such as Fundsmith Equity.

“There are a number of funds that have a similar investment approach to Fundsmith – buying reliable growth companies for the long term – which could sit alongside it,” he explains. “While this approach has beaten value managers hands down for a considerable time, investors should also consider having a blend of fund manager styles to avoid a boom and bust portfolio."

For a value style investment approach – investing in companies that the fund’s managers deem to be undervalued – he suggests Jupiter Global Value Equity (GB00BF5DRJ63), which had assets worth £161.6m at the end of September.

“This fund’s manager Ben Whitmore is a disciplined value investor who looks for companies that are out of favour and trading at attractive valuations, but which have strong finances to see them through the tough times,” says Mr Khalaf. "It’s concentrated with 30 to 40 stocks, but its approach means it has almost no tech stocks and is very underweight the US compared with the world index – unlike Fundsmith Equity. But this has dented performance of late.”

He also suggests Schroder Global Recovery (GB00BYRJXP30), which had assets worth £221.09m at the end of September. 

"This fund is not for the faint-hearted as its managers run a high conviction portfolio in really unloved areas of the market," says Mr Khalaf. "It’s underperformed the world index since launch, but an especially large dose of patience is required for funds like this as they are targeting beaten up companies they think will recover in the long term. It takes a very different approach to Fundsmith Equity."