Sometimes funds just no longer fit with an investment process and as such need to be shed no matter how much they have contributed to your portfolio, according to Downing fund manager Neil Shillito. 
Despite being an early investor in the top performing Fundsmith Equity fund, Shillito has decided to sell the fund from his MI Downing Diversified Global Managers portfolio in favour of new ideas.
“The point that I need to get across is that managers will often sell what is seen to be a very good fund or a very good stock,” Shillito (pictured) said.
Five FE Crown-rated Fundsmith Equity is managed by FE Alpha Manager Terry Smith and has been the best performer in the IA Global sector since its launch in 2010, returning 254.26 per cent, more than double the returns of its average peer.
Performance of fund vs sector and benchmark since launch
Source: FE Analytics
He added: “The reasons are not always what people think. It is not that the manager is in anyway dissatisfied with the fund manager – Terry Smith in this case.”
However, having been a holding in the Downing fund for since its launch, Shillito said as his strategy has evolved the £13.9bn Fundsmith Equity fund has become more of an anomaly.
“The fund didn’t fit with our pairing strategy of putting together a growth fund with a value fund [for example] or a large cap with a small cap in a particular region,” he said.
While he was happy to own it thanks to its stellar performance since launch, Shillito added that it made conversations with clients more difficult.
“When we are talking to investors about what we do and they say ‘well why is that there’, all we can say is that they have caught us out. That doesn’t look good,” he said.
Originally, the newly-listed fund was brought in as part of Shillito’s belief in backing new funds and managers that have yet to make their track record, something FE Trustnet looked at in detail last year.
“I didn’t know Terry Smith but read up on his background when the fund was launched and realised he was a seasoned investor and had done great things,” he said.
“That is what I have always tried to do – find managers who are relatively unknown or at least where the fund is new where you are backing the track record and process of the manager.”
He added: “A lot of investors won’t touch a manager until he has a three-year track record but to my mind that is lunacy – what you are doing there is backing past performance and not a process.”
After so many years however, the fund was more of a legacy holding, he explained, and with the manager focusing more on pairing funds, Fundsmith Equity looked out of place.
“We wouldn’t naturally invest in a global fund because that is our job to decide where we are going to invest and what allocation we are going to have to different regions and so on,” he said.
“So we wouldn’t pair one global fund with another because we wouldn’t naturally invest in a global fund [in the first place].”
As the manager does not typically hold global funds, the second problem with Fundsmith Equity was that the large-cap equity fund had similar holdings to some of the regional funds already in the portfolio.
“Because Fundsmith is so big and invests in such big global companies, it correlates very highly with other funds that we hold and that is not what we want in a portfolio,” he said.
The third reason for selling the fund was that Shillito had concerns over the potential for a market correction this year. If this were to occur, the largest, most liquid stocks and funds are more likely to be sold first.
“We were concerned, as was everybody, about if and when a correction or even a crash was going to come,” he said.
At the end of last month global stocks sold off 5.37 per cent in six trading days – a small correction but significant after a prolonged period of low volatility.
Performance index over YTD
Source: FE Analytics
“We have had the correction though not the crash, nevertheless it is always the case when you get a severe correction or crash that the funds and stocks sold off first are the biggest and the most liquid,” he said.
“Terry’s fund is a very big fund and it is extremely liquid, so while I doubt he has been affected by this correction, had we had a 15 per cent crash we would have seen massive outflows from that fund and from half a dozen other big names we can think of because they are easy meat.”
While Shillito said another correction or even crash is not guaranteed in 2018, with markets approaching new record highs globally the risks remain elevated.
“We thought we can be pretty sure in 2018 that there is going to be some sort of a correction, possibly a crash, so let’s not get caught with our pants down,” he said.
As such, while Shillito does not believe Smith has become a poor manager, “something had to give” to allow new ideas to enter the portfolio.
Although no new holdings have yet been added, due to his concerns over a potential market crash some of the 3 per cent holding previously held in Fundsmith Equity has been placed in a global short position.
As well as this, it has allowed the manager to add to smaller positions such as the £395m Ennismore European Smaller Companies investment trust.
“We were a bit short on it anyway so being able to sell Fundsmith enabled us to put it to a full weight position,” he said.
“The trust is a cracker,” Shillito added. “You can’t get into it except on vary rare occasions and we have managed to get an entry. Being a trust of course the shares are for sale but nobody wants to sell them because it is so good.”
The fund has been the best performer in the FO Hedge/Structured Products – Equity sector over the last decade out of 15 eligible funds returning 138.79 per cent, as the below chart shows.
Performance of fund vs sector over 10yrs
Source: FE Analytics
However, Shillito noted that the trust is somewhat misnamed as it has a large allocation to the UK. Indeed, the investment company is 43.7 per cent weighted to the UK with JD Sports and Costain among its top 10 holdings with 31.3 per cent in German stocks.
“I think originally they named it European smaller companies probably from the point of view that let’s indicate to investors that we are all in Europe now, though that was some time ago and the politics have changed somewhat since then.”
Ennismore European Smaller Companies has a clean ongoing charges figure (OCF) of 2.18 per cent with an additional performance fee.