Fundsmith's Terry Smith Comments On Investment And The Year Ahead
Terry Smith, Chief Executive of Fundsmith, said:
“At Fundsmith we continue to invest in good companies at reasonable valuations and then do the most difficult thing: as little as possible."
On the subject of ETFs, Terry Smith added:
“Last year I warned about the perils of ETFs. This was followed by warnings from amongst others, the Bank of England, the Financial Services Authority, the International Monetary Fund and the U.S. Securities and Exchange Commission in a rare example of closing the door on a stable which may still contain a horse. Since regulators have come in for so much criticism of their loose handling of the financial sector prior to the credit crisis it would be churlish to criticize them for these warnings, and foolish to ignore them.
“One more problem with ETFs became apparent to me in the course of this debate. ETFs are represented as low cost investments. Yet research published during the year demonstrated that ETFs were amongst the largest profit generators for some banks. This seems counterintuitive: how does a low cost product become a major profit contributor? The answer of course is that synthetic ETFs in particular provide banks with innumerable ways to “clip the ticket” of the ETF. The fees paid by the ETF investor are a very small portion of the total revenues which operating the ETF provides. They also deal for the ETF, provide the swap agreements by which it holds its synthetic positions (I wonder who works out whether the bank is providing them a fair price?), and maybe earn leverage, prime brokerage, custodian and registrar fees. The banks also deal for the hedge funds and traders who want to trade the ETF. At about this point, I began to realise why my critique of ETFs had caused so much fury.
“My advice on this matter is simple. A broadly-based index fund is often the best investment you can make in the equity markets. But if you decide this is correct, buy precisely that, an index fund, not an ETF. The only difference between a physical ETF (which frankly is the only sort you should contemplate unless you like the risk of synthetic derivative swaps with counterparty risk) and an index fund is that the ETF is traded on the market as the term “Exchange Traded” implies. Every piece of research I have encountered and all my experience shows that frequent dealing is the enemy of a good investment performance. So why buy an ETF rather than an index fund? You can deal daily in most index funds. The only people who want to deal more frequently than daily are hedge funds, high frequency traders, algorithmic traders and idiots (these terms are not mutually exclusive). Why join them? If you don’t want active management, and mostly you shouldn’t, buy an index fund.
On the subject of dividends being a vital element of total return, Terry Smith continued:
“The historic dividend yield on the Fund at year end was 2.4%. This dividend was covered 2.6 times by earnings. There is only one stock in the Fund that does not currently pay a dividend. This is significant: it is becoming clear that dividends are likely to provide a more significant portion of the total return on equities in the future than they did in the equity bull markets of 1982-2000 and 2003-07. Research from GMO LLC* shows that taking a longer view, during the period 1871-2009 dividends accounted for over 90% of total return on equities in the US market. Moreover, this is not just a US phenomenon. The same patterns hold true across a wide variety of global equity markets. For instance, across markets in Europe, 80% to 100% of the total returns achieved since 1970 have come from dividends (combining yield and real dividend growth).
Commenting on 2012, Terry Smith summarised:
“We view the year ahead with some trepidation. It seems that it has yet to dawn on many of the key participants in the financial crisis that you cannot borrow and spend your way out of a crisis caused by over leverage, and that there is no higher authority than the governments whose credit is now in doubt which can extend further funds to provide a painless ‘solution’ or maybe even a temporary respite. The dawning of this reality is sure to have some very painful consequences.
“However, in contrast the Credit Default Swaps of Nestle have been less expensive than the cost of insuring against default on the debt of European governments and the US Treasury for some time. We are far from believers that the market is always right, but this does suggest that holding shares in major, conservatively financed companies which make their profits from a large number of small, everyday, predictable events is a relatively safe place to be if you have the patience, fortitude and liquidity to ride out the share price volatility which is likely to occur in such circumstances. And that’s exactly where and how the Fundsmith Equity Fund is invested.”
“At Fundsmith we continue to invest in good companies at reasonable valuations and then do the most difficult thing: as little as possible."
On the subject of ETFs, Terry Smith added:
“Last year I warned about the perils of ETFs. This was followed by warnings from amongst others, the Bank of England, the Financial Services Authority, the International Monetary Fund and the U.S. Securities and Exchange Commission in a rare example of closing the door on a stable which may still contain a horse. Since regulators have come in for so much criticism of their loose handling of the financial sector prior to the credit crisis it would be churlish to criticize them for these warnings, and foolish to ignore them.
“One more problem with ETFs became apparent to me in the course of this debate. ETFs are represented as low cost investments. Yet research published during the year demonstrated that ETFs were amongst the largest profit generators for some banks. This seems counterintuitive: how does a low cost product become a major profit contributor? The answer of course is that synthetic ETFs in particular provide banks with innumerable ways to “clip the ticket” of the ETF. The fees paid by the ETF investor are a very small portion of the total revenues which operating the ETF provides. They also deal for the ETF, provide the swap agreements by which it holds its synthetic positions (I wonder who works out whether the bank is providing them a fair price?), and maybe earn leverage, prime brokerage, custodian and registrar fees. The banks also deal for the hedge funds and traders who want to trade the ETF. At about this point, I began to realise why my critique of ETFs had caused so much fury.
“My advice on this matter is simple. A broadly-based index fund is often the best investment you can make in the equity markets. But if you decide this is correct, buy precisely that, an index fund, not an ETF. The only difference between a physical ETF (which frankly is the only sort you should contemplate unless you like the risk of synthetic derivative swaps with counterparty risk) and an index fund is that the ETF is traded on the market as the term “Exchange Traded” implies. Every piece of research I have encountered and all my experience shows that frequent dealing is the enemy of a good investment performance. So why buy an ETF rather than an index fund? You can deal daily in most index funds. The only people who want to deal more frequently than daily are hedge funds, high frequency traders, algorithmic traders and idiots (these terms are not mutually exclusive). Why join them? If you don’t want active management, and mostly you shouldn’t, buy an index fund.
On the subject of dividends being a vital element of total return, Terry Smith continued:
“The historic dividend yield on the Fund at year end was 2.4%. This dividend was covered 2.6 times by earnings. There is only one stock in the Fund that does not currently pay a dividend. This is significant: it is becoming clear that dividends are likely to provide a more significant portion of the total return on equities in the future than they did in the equity bull markets of 1982-2000 and 2003-07. Research from GMO LLC* shows that taking a longer view, during the period 1871-2009 dividends accounted for over 90% of total return on equities in the US market. Moreover, this is not just a US phenomenon. The same patterns hold true across a wide variety of global equity markets. For instance, across markets in Europe, 80% to 100% of the total returns achieved since 1970 have come from dividends (combining yield and real dividend growth).
Commenting on 2012, Terry Smith summarised:
“We view the year ahead with some trepidation. It seems that it has yet to dawn on many of the key participants in the financial crisis that you cannot borrow and spend your way out of a crisis caused by over leverage, and that there is no higher authority than the governments whose credit is now in doubt which can extend further funds to provide a painless ‘solution’ or maybe even a temporary respite. The dawning of this reality is sure to have some very painful consequences.
“However, in contrast the Credit Default Swaps of Nestle have been less expensive than the cost of insuring against default on the debt of European governments and the US Treasury for some time. We are far from believers that the market is always right, but this does suggest that holding shares in major, conservatively financed companies which make their profits from a large number of small, everyday, predictable events is a relatively safe place to be if you have the patience, fortitude and liquidity to ride out the share price volatility which is likely to occur in such circumstances. And that’s exactly where and how the Fundsmith Equity Fund is invested.”