Terry Smith Warns That Dominance of Passive Funds in Global Markets Could Lead to a Major Investment Disaster as Performance Declines in Fundsmith Equity

Terry Smith, the prominent fund manager behind Fundsmith Equity, has raised an alarm about the rapid rise of passive funds and their potential to cause a major investment disaster.

The warning came after another disappointing year for his flagship fund, which posted a modest return of just 0.8% in 2025, far behind the 12.8% growth of the MSCI World Index.

Smith, known for his cautious, high-quality investment strategy, believes the growing dominance of passive investing could have dangerous long-term consequences for both markets and investors.

The Danger of Passive Funds and Overvalued Stocks

Smith’s critique centers around the shift towards passive funds, which track market indices like the MSCI World, rather than relying on active fund managers to pick individual stocks.

While passive funds are typically cheaper and perform well in rising markets, Smith cautions that this trend could distort market valuations by driving up the prices of certain stocks based purely on momentum.

Smith explained that passive funds are leading to inflated stock prices, especially in the case of a small group of tech giants, which he refers to as the “Magnificent Seven”—companies like Apple, Microsoft, Meta, and Alphabet.

According to Smith, the dominance of these stocks in indices is problematic because investors in passive funds have no way of limiting their exposure to them.

He points out that owning such a concentrated portion of a portfolio in these tech companies represents an unnecessary risk.

“We wouldn’t invest in all five drinks companies in our universe, even if the sector looked good.

A fund should be a portfolio, not a sector bet,” he said.

A Focus on Quality Over Market Trends

Fundsmith’s investment strategy is built on the idea of picking high-quality global companies with strong returns on capital and advantages that are difficult for competitors to replicate.

This approach has served the fund well since its launch in 2010, delivering an average annual return of 13.5%.

However, over recent years, the dominance of tech stocks has made it increasingly difficult for Smith’s fund to keep up, particularly as these large companies have driven market growth.

Over the past five years, Fundsmith’s annual average return has slowed to just 5.7%, significantly trailing the MSCI World Index’s return of 12.7%.

This underperformance has led some critics to question whether Smith’s more selective, concentrated approach can compete with the sheer weight of index funds that benefit from the tech boom.

Is AI the Next Big Bubble?

Smith also addressed the rise of AI companies and the potential for an AI bubble.

While he acknowledges that AI could bring about a major shift in the way businesses operate, he remains skeptical about whether the enormous investments flowing into AI companies will yield returns that justify their inflated valuations.

“AI may transform the way we work, but we have to ask if the returns on the massive amounts of capital being invested will be enough to support these valuations,” Smith remarked.

If these companies fail to meet expectations, it could lead to another burst bubble.

The current enthusiasm for AI reminds Smith of the dotcom boom, when index funds were a much smaller part of the market.

The rapid rise of passive investing in recent years has made tech stocks’ dominance a self-fulfilling prophecy, according to Smith.

He believes that this shift is setting the stage for a market correction that could spell disaster for those heavily invested in these funds.

The Impact of a Weak Dollar on Fundsmith’s Performance

Another factor contributing to Fundsmith’s recent underperformance has been the weakness of the US dollar.

Since the fund holds a significant number of global assets, a weaker dollar has negatively affected the sterling value of its portfolio.

Smith acknowledged that while this factor has been a challenge, it is not the main cause of the fund’s struggles over the past year.

Staying True to His Investment Strategy

Despite these challenges, Smith remains committed to his investment philosophy.

He emphasized that the fund would not buy stocks simply because they dominate the index or have high market capitalizations.

“We won’t be buying shares in companies just because they are large and dominate the index weightings and performance, unless we believe they are good businesses,” Smith stated.

He also reminded investors that Fundsmith’s strategy is designed for the long-term, and outperforming the market every year should not be expected.

While the recent underperformance might be discouraging for some, Smith insists that the fund’s strategy will remain focused on delivering quality over short-term gains.

Looking Ahead: A Cautious Outlook

Looking ahead, Smith is wary of the continued rise of passive investing and its potential impact on the broader market.

While he doesn’t know exactly when or how the market will correct itself, he is confident that the shift to passive funds is unsustainable in the long run.

“If we are right in diagnosing the shift to index funds as a major cause of our recent underperformance, the eventual outcome could be disastrous,” he said.

Smith’s comments serve as a reminder to investors that market trends, no matter how popular or profitable in the short term, are not always sustainable.

While the allure of passive investing might be strong, particularly in a rising market, Smith cautions that it could lead to greater volatility and risks in the future.

Conclusion: A Word of Caution to Investors

For now, Terry Smith remains firm in his belief that sticking with a quality-focused, long-term investment strategy is the best approach for Fundsmith.

While the challenges of 2025 have been tough, he’s clear that he intends to continue refining his approach without chasing trends.

Investors, however, should take note of the broader implications of the passive investing boom and consider whether they’re prepared for the potential fallout when the market corrects itself.