Has Terry Smith lost his mind?!
Has Terry Smith lost his mind?!
Typically, he doesn’t trade much.
But in the first six months of 2026, he turned over more than 50% of his portfolio.
He even announced a major shift in his investment strategy.
Let’s see what’s happening.
Who is Terry Smith?
Terry Smith is often called “The English Warren Buffett”.
He’s considered as one of the best quality investors in the world.
Terry typically is very straightforward and an independent investor.
His background looks like this:
Grew up in East London, was at the top his class in history at Cardiff, and entered banking at Barclays in the 1970s.
In 1992, he wrote Accounting for Growth, a book that exposed corporate accounting tricks and was so controversial that it got him fired.
Launched Fundsmith in 2010. Today, it manages £12 billion and has achieved an impressive 13.1% CAGR after fees since inception.
Pieter even had the opportunity to have dinner with Team Fundsmith in Omaha at Gorat’s last year (Warren Buffett’s favorite steakhouse).
Investment Style
Terry Smith’s philosophy is simple.
It comes down to three steps:
1. Buy Good Companies
Terry Smith looks to buy high-quality businesses that dominate their markets.
High ROCE: Look for a Return on Capital Employed of more than 15–20%
Wide Moats: Focus on companies with pricing power and high gross margins
Cash is King: Prioritize strong organic growth and businesses that convert a lot of their net earnings into free cash flow.
“I am constantly amazed at the number of people who talk about investment and spend most or all of their time talking about asset allocation, sector weightings, economic forecasts... and never mention any need to invest in something good.” — Terry Smith
2. Don’t Overpay
While quality comes first, valuation still matters.
He is willing to pay a fair premium for an exceptional business but tries to avoid overpaying.
3. Do Nothing
Minimizing trading keeps fees low and lets compounding do the work over time.
Patience has been one of Terry’s main advantages.
The Fundamentals
Fundsmith does hold a portfolio of companies with great fundamentals:
Performance
Over the long term it has allowed the fund to outperform.
Fundsmith generated a CAGR of 13.1% after fees since 2010.
But guess what?
Terry Smith has underperformed every single year over the past 5 years:
Which brings us to the letter Terry Smith recently wrote to his investors.
You can read it here:
Shareholder Letter Terry Smith
There are two things I want to focus on today:
Why he thinks he has underperformed
How he is shifting his strategy
Why he has underperformed
The letter says the fund underperformed because investors cared more about momentum than business fundamentals.
I think that’s true, and we’ll explain Terry’s argument in a moment.
How he is shifting his strategy
Because of that, Smith says that the fund will be changing strategy and taking momentum into account.
That means the fund will be buying and selling more than it has in the past.
In other words, Buy Good Companies and Don’t Overpay are still the core principles.
But there will be a little less Doing Nothing going forward.
The interesting part is why Terry is making this change.
It’s not because he thinks it’s the best investment decision.
It’s because if he didn’t adapt, the fund would eventually go out of business.
“We run open-ended funds, and you can and increasingly have been taking money out, we suspect mostly to join the exodus from active to passive, or possibly to invest in managers who profess that they understand quality better than we do. They may be right, or they may just be closet momentum investors, which will be fine until it isn’t. However, there will be little point being proved right about the dangers of passive or momentum investment after our Fund has closed… In a market in which share price moves of 33% per day for even large stocks are not uncommon a buy and hold strategy can only work if you are not subject to flows, and we are. Sticking to our current approach may well fall foul of the adage that the market can remain illogical longer than we can remain in business. You should therefore expect that we will be more active in the future.”
Passive Investing and Momentum
Terry has been talking about the markets becoming increasingly more momentum driven for quite some time.
And there’s no argument that he’s wrong,.
Just look at how momentum has been outperforming everything else lately:
He starts his letter with a simple point.
More people are investing in ETFs.
At the same time, excitement around AI is growing.
As a result, the market cares less about the underlying businesses.
“A market which is dominated by so-called passive or index funds (of which the majority are ETFs) and the boom surrounding AI which have combined to produce a market dominated by momentum rather than any fundamental factors like profitability, returns on capital and growth — in other words the factors we focus on.”
What’s the point of passive investing?
Passive investing was popularized by John Bogle, who founded Vanguard.
Bogle’s argument was pretty simple:
Most active funds fail to beat the market. On top of that, they charge fees that reduce your returns.
Index funds remove those high fees and simply match the market’s average return.
As a result, investors often end up with more money.
Makes sense.
But if that argument holds true, then shouldn’t the index and the average manager perform similarly?
They used to, but that’s started to change:
“In the UK, for example, Vanguard’s UK All Share tracker has made 66% over five years, trouncing the average UK equity fund’s return of just 32%.”
Some people argue that this is evidence that the average fund manager is terrible.
According to them, it’s why everyone should just switch to passive.
Passive investing is now driving the market
That could be true.
But Terry offers another explanation.
A momentum driven feedback loop:
There’s pretty good evidence this is correct.
Here’s the performance of the S&P 500 vs Hedge Funds from 2007 to 2016.
I’d say that’s a pretty good representation of passive vs active performance.
They run close together until somewhere in 2012 or 2013.
Afterwards the S&P 500 starts to outperform.
You can see the flows of capital of active versus passive here:
Money flowing into active funds peaked around 2012 or 2013.
Since then, those flows have declined.
Meanwhile, money has kept pouring into passive funds.
This creates two powerful feedback loops:
Passive funds: More money comes in → they buy more stocks → prices rise → performance improves → even more money comes in.
Active funds: Money flows out → they sell stocks → prices fall → performance gets worse → even more money flows out.
As a result, the stocks passive funds own become more expensive, while the stocks active funds own become cheaper.
That makes passive funds look even better and active funds look even worse, simply because of where the money is flowing.
Today, passive funds manage more than 60% of all assets under management.
This has never happened before.
Trades set prices
The stock market is like a big auction.
Stock prices change every time someone buys or sells.
Every Trade Needs Two Sides
You can only buy a stock if someone else is willing to sell it.
And you can only sell a stock if someone else is willing to buy it.
It sounds obvious, but it’s an important concept.
How the auction works
To make trades happen, the stock market uses an ongoing list of offers called the Bid and the Ask.
The Bid: is the highest price a buyer is currently willing to pay for the stock
The Ask: is the lowest price a seller is currently willing to accept
The difference between these two numbers is called the spread.
It’s all tracked in the order book, which looks like this:
In the image, there are a lot of people willing to buy at $37.37.
But the lowest price anyone is willing to sell is $37.38.
As a result, no transaction will take place.
How the Price Actually Moves
For a stock price to move, either the buyer or the seller has to give in.
If buyers are eager: They stop waiting and agree to pay the seller’s asking price. The trade happens, and the stock price moves up. If more buyers keep doing this, the price keeps rising.
If sellers are eager: They accept the buyer’s lower price. The trade happens, and the stock price moves down. If more sellers keep doing this, the price keeps falling.
Who’s making the trades?
If trades set prices, then we need to understand who’s making the trades.
Terry Smith tells us:
“Moreover, whilst AUM in index funds is now more than 60%, in terms of volume of trades, active fund managers are an even smaller minority than this implies. According to Cboe Global Markets, having been 80% of trades in the 1990s, active funds share of trades is now down to just 10%.”
When Jack Bogle introduced index funds, the idea was simple.
Index funds would stay small and benefit from the research done by professional stock pickers.
At the time, active investors made up almost the entire market.
But that’s no longer true.
Today, a large part of the market is driven by index funds, ETFs, quant funds, and momentum traders.
Only a small share of trading comes from investors who actually read annual reports and research individual companies.
Index funds and ETFs follow a very simple strategy:
Money comes in → Buy
Money goes out → Sell
Index funds and ETFs don’t care about price.
They simply buy or sell based on money flowing in or out.
Think back to the auction example.
If a lot of money flows into a fund and there aren’t many sellers, the price has to rise until someone is willing to sell.
The opposite is also true.
If a lot of money flows out and there aren’t enough buyers, the price has to fall until someone is willing to buy.
What happens next?
When index funds buy and sell without looking at price, they change how the stock market works.
But what happens if that buying and selling hits a market with fewer buyers and sellers than people expect?
In Part 2, we’ll show how this is already creating bigger swings in stock prices.
We’ll also explain why it could become a serious problem for the U.S. retirement system.
Stay tuned.
Conclusion
That’s it for today.
I think the move Fundsmith made is strange.
They are switching from quality to momentum right now.
They might be making the switch at exactly the wrong time.
Did you like this?
This was an article TJ wrote for Compounding Dividends.
You can discover more here:
Everything In Life Compounds
Pieter
Book
Order your copy of The Art of Quality Investing here
Used sources
Interactive Brokers: Portfolio data and executing all transactions
Fiscal.ai: Financial data
What stood out to me wasn't the shift in strategy itself, but the constraints behind it. Terry Smith manages an open-ended fund, so investor flows become part of the investment process. It also made me think about why someone like Warren Buffett doesn't face the same pressure. The structure of the vehicle seems to determine how much flexibility an investor actually has.
The most interesting tension here is that Smith may still be right about quality, yet unable to wait long enough for the market to prove it. Once investor redemptions begin influencing portfolio decisions, the fund is no longer managing only business risk and valuation risk, it is also managing survival risk. That makes the move understandable, but it also raises a difficult question: when does adapting to market structure become abandoning the very discipline that created the long-term record?