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[See CPD webinar on introduction to factor-based investing]

• Fundsmith’s performance vs MSCI World is stellar
• But performance vs MSCI World Momentum Factor is marginal
• Is Fundsmith knowingly or unknowingly a Momentum investor?

Stellar performance
If there’s one word to describe the performance of Terry Fundsmith’s Fundsmith Equity Fund, it would be “stellar”.
Beloved by retail investors and advisers alike, it’s a key holding in many of the portfolio we see that are run by financial advisers.
The firm’s values are clearly set out “No performance fees, no nonsense, no shorting, no market timing, no index hugging, no hedging etc”.  All this combined with great results, and it’s a compelling proposition.
But in this article, we set out to answer four questions:

1. Is Fundsmith a Momentum investor?
2. Where and how has Fundsmith added value?
3. Is Fundsmith fund “hugging” a Momentum index?
4. Are Fundsmith-like returns replicable by lower cost index strategies?

In summary, the answers are: respectively: Possibly, Sector Allocation, Definitely Not, and Yes.
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What is Momentum investing?
MSCI defines momentum factor as referring to “the tendency of winning stocks to continue performing well in the near term. Momentum is categorized as a “persistence” factor i.e., it tends to benefit from continued trends in markets”[1].
Following the lows of the Global Financial Crisis, it’s been a great time to be a Momentum investor.

Question 1: Is Fundsmith a Momentum investor?
What’s the right comparator?
The Fundsmith Equity fund quite rightly uses MSCI World Index as a performance comparison on its factsheet.  Comparisons against UK equity funds or indices would not be appropriate.   In our research around factor-based investing, we thought it would be interesting to plot how the performance of a popular global equity fund like Fundsmith Equity fared against the various factor-based world equity indices.
We were astonished to see that the performance was almost identical to the iShares EDGE MSCI World Momentum Factor UCITS ETF (the “Momentum ETF”).
Fig.1. Close call between Fundsmith & Momentum factor for trouncing MSCI World

Source: Elston research, Bloomberg data. Total Return in GBP terms as at 31-Dec-20
Indeed, over the last 5 years from Dec-15 to Dec-20, Fundsmith has delivered a cumulative total return of +137.39%, compared to iShares Edge MSCI World Momentum Factor ETF’s return of +132.77% and +90.23% for iShares MSCI World Equity ETF.  In annualised returns this translates to +18.85%, +18.39% and +13.71% respectively[1].
The correlation between the strategies from December 2015 to December 2020 is 84.3%.
[1] As at 31st December 2020

How about 2020 performance?
In 2020, the semi-annual rebalancing of the Momentum index potentially worked in its favour as it is not wedded to favourite positions: it simply looks at Momentum scores.  In 2020, iShares EDGE MSCI World Momentum ETF returned +24.85% in GBP terms, compared to Fundsmith Equity’s +18.23% and iShares MSCI World +11.81%.

Fig.2. Fundsmith vs Momentum in 2020

Factor investing: between active and passive?
Factor-based index investing has sometimes been described as being somewhere between passive investing (cap-weighted beta) and active investing (non-index).  Macro factors and style factors explain some of the difference between market beta and active returns, that were previously attributed to manager alpha.
In the chart below, we compare the annualised performance of the world equity ETF (beta), the Momentum ETF (style factor) and the additional Alpha of Fundsmith relative to that Momentum ETF, effectively using the Momentum ETF as another benchmark.
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Fig.3. Relative Return Comparison: Fundsmith Equity vs iShares EDGE MSCI World Momentum  Factor ETF

So for evaluating manager skill, which is the right benchmark: World Equities against which both Fundsmith Equity and a low cost Momentum tracker look great, or – if Fundsmith is indeed a Momentum-style investor – a Momentum benchmark, against which Fundsmith has still outperformed – but only marginally?
Fundsmith describes his process as “Quality focused” and yet performance is very different to a Quality factor.  Does this meant that Fundsmith is – knowingly or unknowingly – a closet “Momentum” investor?
 
Applying a factor lens to active managers
By applying a factor lens to traditional active managers we can see what factors those managers are knowingly or unknowingly allocating to, and hence to what extent their performance relates to a particular style factor.
The Fundsmith Equity fund is a “true active” fund using high conviction, and high concentration.  The manager’s stated philosophy selects companies based on their quality.
We can see that Fundsmith and MSCI World Momentum Factor index both have in common a high concentration to Information Technology, Health Care and Consumer Staples.  Fundsmith’s less constrained and more concentrated approach means that this sector concentration is even more extreme as he zero weights most other sectors, which the Momentum index cannot do.
Naturally there is significant overlap in the underlying stock within both Fundsmith and the Momentum ETF, but with Fundsmith able to take larger active weights.
Given Fundsmith’s focus – whether by accident or design – on companies with persistent share price momentum, a momentum index could be a more relevant comparator than a traditional cap-weighted world equity index for the Fundsmith Equity fund.
 
Question 2. Where and how has Fundsmith added value?
Performance Attribution
We ran an attribution analysis comparing the Fundsmith Equity fund to the Momentum ETF for the period from June 2016 to December 2019, a period where all look-through data is available.
In aggregate Fundsmith returned +75.76% outperforming Momentum ETF which return +69.48%. 
In terms of Total Returns, Fundsmith’s picks in the Information Technology sector delivered +145.22%, compared to Momentum ETF’s +156.32%, an underperformance of -11.1%.  This was offset by Fundsmith’s pciks in the Health Care sector which returned +77.66%, compared to +67.58% for the Momentum ETF.  An outperformance of +10.08%.  Fundsmith’s picks in the Consumer Staples sector generated +35.62%, compared to +35.12% for the Momentum ETF.
After adjusting each sector for average weights, the large relative overweight in Information Technology – an advantage of a more concentrated approach – meant that technology was the largest relative contributor to overall return deliver 35.82ppt of the +75.76% return.  Similarly, for Momentum, information technology delivered 26.5ppt of the +69.48% return.
In summary for the time period under review Fundsmith has been excellent at sector selection.  Good in stock selection within the Health Care sector was offset by poor stock selection in the Information Technology sector.  Stock selection in the Consumer Staples sector added almost no value.
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Fig.4. Sector-level Contributions To Return

The conclusion is that Fundsmith added greatest value by selecting the best performing sectors, where share price momentum was greatest.  There was moderate additional value from fund selection, and some detraction from currency effect.
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Fig.5. Attribution analysis

Holdings analysis
We looked at the average largest relative overweights for the Fundsmith Equity fund relative to the Momentum ETF. 
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Fig.6. Security-level Contribution To Return

Fundsmith is “true active” because he is taking large absolute and relative bets relative to securities’ index weights be that in a traditional cap-weighted index or in the Momentum factor-weighted index.  During the period under review, Paypal, Idexx and Amadeus were the largest contributors to returns.
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Fundamentals
Interestingly, looking at aggregate valuations, the overall Price Earnings Ratio (PER) for Fundsmith and for Momentum is not dissimilar, whilst Price Book Value (PBV) ratios – a traditional value metric – and debt levels were far higher for Fundsmith than Momentum.
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Fig.7. Valuation Comparison

Question 3: Is Fundsmith Equity hugging the Momentum index?
No.  Not at all.  As a far more concentrated portfolio there are high levels of active weights relative to the much more diverse MSCI World Momentum Index. 
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Fig.8. Top 5 relative weights

Question 4: Are Fundsmith-like returns replicable by lower cost index strategies?
The most interesting element of our analysis is not finding two strategies that take a similar approach to different outcomes, but two strategies that take a different approach to a similar outcome.  This is consistent with the concept of factors being the underlying drivers of returns.
Fundsmith is and remains a vindication of the potential value add of active management, and the ability to deliver returns well in excess of the market beta.
However, if we start looking at the “market” not just from the context of traditional capitalisation weightings, but using a more granular factor-based approach, we can get more insight as regards value add.
Furthermore, we can see that that level and style of stellar returns are available to index investors too, in upward trending markets but at a cost of 0.30%, instead of 0.95%.
The holdings or “ingredients” might be different, but the factors or “nutrients” might be the similar.

Similarities and Differences
So what are the similarities and differences between methodologies?
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Similarities

• High concentration (sector-level): high concentration of sector exposures in Consumer Staples, Health Care & Information Technology at present.
• Max position sizes: Max positions of 5% in the Momentum Index - much higher than the traditional MSCI World Index, but not dissimilar to the larger position sizes within Fundsmith Equity
• Outcome: Both strategies – via very different methodologies – end up with a similar overall “momentum” philosophy, namely “backing winners”.

Differences

• Investment approach: stating the obvious, Fundsmith’s Equity Fund is a subjective manager-based approach; Momentum factor ETFs reflect a systematic rules-based approach
• Number Holdings: Fundsmith’s Equity fund is concentrated in 30 holdings.  The Momentum factor ETF has 350 or so holdings.  The Momentum factor ETF is therefore carries less idiosyncratic risk.
• Turnover: But given the dynamic nature of these trends, and semi-annual rebalancing, the Momentum index turnover is high at 149.48%[1].  Fundsmith’s turnover, by contrast is much much lower by design.
• Cost: the Fundsmith fund delivered performance at a cost of 0.95% OCF, the iShares Edge World Momentum Factor UCITS ETF delivered similar performance at a cost of 0.30%

Summary
Fundsmith’s performance is undeniably excellent, but is consistent with that of a Momentum-style investment strategy.
Fundsmith’s “Alpha” can be measured not just against MSCI World, but against this Momentum Index.  Using the standard MSCI World as a comparator implies Fundsmith’s Alpha is a phenomenal 5.14ppt pa over the last 5 years.  Using the MSCI World as a comparator implies Fundsmith’s Alpha is just 0.46ppt pa.
Incorporating factor-based exposures as a hybrid on the spectrum between traditional cap-weighted passive, and true active, creates more options for portfolio managers looking to isolate and capture specific styles and exposures without having to materiallyincrease either the risk budget or the fee budget.

[1] MSCI factsheet as at December 2020 for last 12 months

[5 min read, open as pdf]

• Tech performance is skewing cap-weighted indices
• Increased concentration reduces diversification
• Using cap-weighted indices is an active choice

 
Tech performance is skewing cap-weighted indices
The run up in technology stocks and the inclusion of Tesla into the S&P500 has increased both sector concentration and security concentration.  The Top 10 has typically represented approximately 20% of the index, it now represents 27.4%. 
The chart below shows the Top 10 holdings weight over time.

​Rather than looking just at Risk vs Return, we also look at Beta vs Correlation to see to what extent each strategy has 1) not only reduced Beta relative to the market, but also 2) reduced Correlation (an indication of true diversification).  Strategies with lower Correlation have greater diversification effect from a portfolio construction perspective.

Ironically, the last time the index was anything close to being this concentrated was back in 1980 when IBM, AT&T and the big oil majors ruled the roost.

From a sector perspective, as at end December 2020, Information Technology now makes up 27.6% of the index.

Increased concentration reduces diversification
This level of concentration is indeed skewing indices that rely on a traditional market capitalisation-weighted (cap-weighted) methodology, and does therefore reduce diversification.
But the issue of the best performing stocks getting a larger weighting in the index, is not an accident of traditional index design.  It’s its very core.  Cap-weighted indices reflect the value placed on securities by investors, not the other way round.

We should not therefore conflate the debate around “active vs passive” investment approaches, with the debate around index methodology.

If portfolio managers are concerned about over-exposure to particular company or sector within a cap-weighted index, they can either chose an active, non-index fund, that is not a closet-tracker.  Or they can access the target asset class through an alternatively weighted index, which uses a security weighting scheme other than market capitalisation.

Using cap-weighted indices is an active choice
The decision to use a fund that tracks an cap-weighted index is an active choice.  And for those seeking differentiated exposure, there is a vast range of options available.

We categorise these into 3 sub-groups: Style, Factor-based and Risk-based.

1. Style-based: for example: Value, Growth, Income.  This is the classical style-based approach.  Value investing traces back to Graham & Dodd’s research in the 1930s.
2. Factor-based: for example: Value, Size, & Quality.  Factor-based investing weights securities by their internal fundamental characteristicss that relate to their expected drivers of returns: for example securities included in a Quality index would be included based on profitability and/or Return on Equity metrics.  Min Volatility (lowest and Momentum relate to the performance of the security rather than its fundamentals.  Our recent CPD webinar explores factor-based investing in more detail.
3. Risk-based: probably the least developed area.  Risk-based investing weights securities by their relationship to each other in order to target a particular target risk characteristic.  Examples include: Max Deconcentration (aka Equal weighted); Max Diversification; Max Decorrelation; Max Sharpe; Min Variance, Risk Parity (aka Equal Risk Contribution) and Managed Risk.  Our recent CPD webinar explores risk-based investing in more detail.
4. Min Volatility or Min Variance? What’s the difference? Semantics, but for differentiation, we refer to Min Volatility when a strategy ranks securities by their volatility, to include only those lowest volatility stocks (hence used when referring to Factor-based strategies).  We refer to Min Variance when a strategy looks at risk and correlation structure between stocks to target a “minimum variance portfolio” of those securities (hence used when referring to Risk-based strategies).  So similar, but different.

With that array of index methodologies for US equities to choose from, there’s no excuse for complaining about being fed-up with the traditional cap-weighted approach.  Index selection, depends, of course, on portfolio construction objectives, and index methodology due diligence remains key.

How have US equity risk-based strategies fared?
Risk-based strategies have been in existence for some time, so we are able now to consider 10 year data (to December 2020, in USD terms).  In terms of risk-adjusted performance, Managed Risk index strategies have fared best, whilst Min Variance has delivered higher returns for similar levels of risk of a Max Diversification strategy.  Meanwhile Equal Weight has actually exhibited greater risk than traditional cap-weighted approach.

In this respect, Equal Weight (Max Deconcentration), also disappoints delivering higher beta and >95% correlation.  Likewise Min Variance, whilst delivering on Beta reduction, does not deliver on decorrelation.  Max Diversification delivers somewhat on decorrelating the strategy from the S&P500, but only modestly, whilst Managed Risk achieves similar decorrelation, reduced beta and better returns.  Finally Risk Parity 10% Volatility cap has delivered most decorrelation as well as beta reduction.
For more information about the indices and funds used to represent these different strategies, please contact us.
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Summary
There are a broad range of alternatives to cap-weighted index exposures.  But consideration of style-, factor- or risk-based objectives will necessarily inform portfolio construction.

• Fiscal and policy support should keep growth shock short and sharp
• Inflation looks bottled – for now, but this is the key focus
• Asset price recovery was welcome but vigilance now required

 
Find out more
For more insights and information on research, portfolios and indices, visit:
www.elstonsolutions.co.uk or NH ETF<Go>

[3 min read, open as pdf]

• Growth shock is short and sharp, for now
• Even lower for even longer interest rates
• Recovery extended, but vigilance required

 
Growth shock is short and sharp
The medium-term outlook for growth points more to a “short sharp shock” rather than a protracted downturn that followed the Global Financial Crisis.  However vigilance around economic growth, and ongoing dependency on vaccine rollout, fiscal and monetary policy support remains key.

Even lower for even longer interest rates
Even lower for even longer interest rates underpins an accommodative strategy to support recovery: but also has created frothiness in some asset classes.

Low nominal and negative real yields is forcing investors into refocusing income exposures, but should not lose sight of quality.

Inflation in a bottle: for now
Inflation caught between growths scare on the downside and supportive policy on the upside.  Should inflation outlook increase, nominal bond yields will be under greater pressure and inflation-protective asset class – such as equities, gold infrastructure, and inflation-linked bonds can provide a partial hedge.

Trade deal with EU should reduce GBP/USD volatility
The 11th hour trade deal concluded in December between the UK and the EU should dampen the polarised behaviour of GBP exchange rate, with scope for moderate appreciation, absent a more severe UK growth shock.

Market Indicators: recovery extended
Market indicators suggest equities are heading into overbought territory and whilst supported by low rates and bottled inflation, are looking more vulnerable to any deterioration in outlook.  Incorporating risk-based diversification that adapts to changing asset class correlations can provide ballast in this respect.