Terry Smith labels ETFs a ‘dream’ for active managers

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Star fund manager Terry Smith has labelled ETFs a “dream” for active managers even though he blames index strategies for underperformance in his emerging markets investment trust.

His Fundsmith Emerging Equities trust has returned shareholders 5.5 per cent since inception in June 2014 compared to 29.3 per cent in the MSCI Emerging & Frontier Markets index. The fund’s net asset value has risen 8.3 per cent over the period.

Speaking at an investment seminar in the City, Smith pointed out that the 10 largest constituents of his investment trust produced a return on operating capital employed (ROCE) of 45 per cent in 2016, whereas the the 10 largest constituents of the MSCI index have a collective ROCE of 12 per cent.

High returns on operating capital employed is one of the key metrics Smith uses to determine a good company.

Smith also looks for growth from reinvestment of cashflows, revenues built on “everyday, small-ticket, repeat, predictable transactions” and firms able to protect returns against competition.

The largest holdings in the Fundsmith investment trust include Godrej Consumer Products with a 3.8 per cent weighting, and Emami, Britannia Industries, Philippine Seven Corp and Marico, which each represent a 3.6 per cent weighting.

But Smith says emerging ETF flows show the index has become distorted capturing “100 per cent “of outflows in 2016 from active funds and bolstering the share prices of index constituents regardless of quality or valuation.

Emerging market ETFs saw £20bn of inflows in 2016 compared to a little over £20bn of outflows from active strategies, data from EPFR Global shows.

“It gets invested with the ETF provider into the index,” Smith says. “So all of those companies that we don’t own have been the recipient of inflows being invested in shares through the ETFs irrespective of quality and irrespective of valuation.”

Smith points to Samsung, the largest constituent of the MSCI index at 3.7 per cent, as the best illustration of the distortive impact of index funds, with its share price rising 57 per cent since the start of last year.

“You look at what’s happened during the period concerned, other than paying a dividend, everything else is an utter disaster. Samsung Galaxy blows up, catches fire, you get banned from taking it on an aeroplane even if it’s switched off. Then management get arrested and charged with fraud.”

Smith continues: “This company has been through an increasingly terrible time during which the share price has become a moonshot. It’s the biggest share in the index, that’s where the ETF money has been going. It doesn’t matter whether it’s any good or not.”

Despite the negative impact ETF flows have had on Smith’s fund, he says they are a double-edged sword.

“You often hear people in the fund management industry bemoan the rise of ETFs or index investing and saying it distorts everything. On one level, yes it does, on another level it’s the best thing that could ever happen to you.

Smith adds: “Every active manager that really believes in what they’re doing should have one dream of one day being the only active manager left in the world. They’ll be the only person left with a mandate to think.”