Terry Smith, manager of the Fundsmith Equity Fund, recently addressed investors to explain a period of underperformance after years of strong returns. Since its launch in 2010, the fund has delivered a total return of 593%, surpassing the market’s 531% over the same period. However, the fund experienced a notably weaker performance over the past six months, which Smith attributes to shifts in market dynamics rather than his investment strategy.

Smith points to the growing dominance of passive investment vehicles, such as index trackers and exchange-traded funds (ETFs), as a key factor disrupting traditional market behavior. Unlike active fund managers who base decisions on company fundamentals—profitability, return on capital, and growth rates—passive funds often buy and sell according to market weighting or momentum algorithms, effectively trading based on price movements rather than underlying business value.

This change in investor behavior, Smith argues, has reduced the influence of fundamentally driven investors and led to markets increasingly shaped by mechanical flows. He highlights the performance gap between passive and active funds as evidence of this trend. For instance, Vanguard’s UK All Share tracker delivered a 66% return over the past five years, more than double the 32% return from the average UK equity fund. In the United States, the total market return was 83%, compared with 59% for the average open-ended mutual fund.

Originally, passive trackers were expected to yield average returns at lower costs, rather than outperform active managers. Their substantial recent outperformance suggests that many passive funds have begun making concentrated bets in certain sectors and stocks, contributing to market distortions and the formation of feedback loops that inflate valuations. Smith warns that such dynamics could amplify the severity of any future market corrections, which investors may not be adequately prepared for.

Smith acknowledges that his investment approach—focused on high-quality companies and avoiding overpayment—has faced challenges amid these evolving market conditions. He admits to being slow to recognize the shift toward momentum-driven trading and concedes that some stock selections have not justified their high valuation multiples during this period of market upheaval. Nevertheless, he stands by the fundamental premise that the growing influence of non-fundamental investors alters the way prices are set.

In response, Smith is adjusting his strategy to incorporate momentum factors alongside traditional valuation metrics, recognizing that market irrationality can persist longer than anticipated. He cautions investors to consider not only fundamentals but also fund flow trends when making decisions.

For individual investors, the changing environment calls for greater diversification and self-awareness, particularly concerning risk tolerance. In a market increasingly driven by sentiment and momentum, maintaining a balanced portfolio and a clear understanding of one’s risk capacity may help navigate heightened volatility. As a practical reminder, unexpected market shifts can upend even the best-laid plans.