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Are you taking a bigger risk than you think by investing in Terry Smith’s Fundsmith Equity?

Investors cannot get enough of Terry Smith, the man behind the nation’s most popular investment fund, Fundsmith Equity.

Top of the charts

Interactive Investor and Willis Owen have both just reported that the fund was the best selling unit trust on their platforms during the recent ISA season. This is not unusual. Fundsmith has been topping the bestseller charts for years.

Every industry throws up a star performer. Before Terry Smith, it was Neil Woodford, whose long-term track record was phenomenal but has been shocking for the past three years.

What goes up

It isn’t easy to stay the top of the tree for long. If Neil Woodford can lose his way, anybody can. So what about Terry Smith?

There’s a lot here to admire in his strategy. Fundsmith Equity invests in a spread of global stocks and shuns clever tricks such as short-term trading strategies. It operates stringent investment criteria by focusing on high quality businesses that can sustain a high return on operating capital employed, and whose advantages are difficult to replicate.

Follow the rules

Smith shuns businesses that need significant leverage to generate returns, and seeks out those who can reinvest their cash flows at high rates of return. He also favours businesses that are resilient to technological change and available at attractive valuations. These rules are all worth applying to your own portfolio.

Fundsmith invests in in a concentrated pool of just 20 or 30 equities, even after growing into a £18.6bn behemoth. That is a brave move. This is not a covert index tracker. Nor is it a one-stop shop international fund. Mr Smith is out to thrash the market, which he’s done. It does increase the risk, though.

God bless American tech

Two thirds of the fund is invested in the US. Of the remainder, 17.4% is invested in the UK, plus Denmark, Spain, France and Finland. So check what exposure you already have to the States to avoid overdoing it (although as the world’s biggest economy, you’ll want a fair bit).

US markets have done brilliantly, driven by the tech giants. Apple, Amazon, Netflix and Google-owner Alphabet do not feature but the fund is still tech heavy, with the top 10 including PayPal, MicrosoftFacebookIntuit and others.

Long-term performance has been excellent, returning 269.6% from launch date on 1 November 2010 to the end of last year. That smashes MSCI World, which grew 128.4% over the same period, although this benchmark is not exact, given that Fundsmith is not really a world fund. It is primarily a US fund. 

Risk and reward

So how does it fare against the US benchmark? Over five years it is up 167%, against 103% from the average North America fund, according to the Investment Association. So it has smashed the US too. If you own this fund, you chose well.

Fundsmith Equity is nonetheless exposed to a US market reversal. It doesn’t have any emerging market equity or bond exposure to hedge against that. However, most investors will reckon the risks are massively outweighed by the super-sized returns.

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John Mackey, CEO of Whole Foods Market, an Amazon subsidiary, is a member of The Motley Fool’s board of directors. Suzanne Frey, an executive at Alphabet, is a member of The Motley Fool’s board of directors. Teresa Kersten, an employee of LinkedIn, a Microsoft subsidiary, is a member of The Motley Fool’s board of directors. Randi Zuckerberg, a former director of market development and spokeswoman for Facebook and sister to its CEO, Mark Zuckerberg, is a member of The Motley Fool's board of directors. Harvey Jones has no position in any of the shares mentioned. The Motley Fool UK owns shares of and has recommended Alphabet (A shares), Amazon, Apple, Facebook, Intuit, Microsoft, Netflix, and PayPal Holdings. The Motley Fool UK has the following options: long January 2020 $150 calls on Apple and short January 2020 $155 calls on Apple. Views expressed on the companies mentioned in this article are those of the writer and therefore may differ from the official recommendations we make in our subscription services such as Share Advisor, Hidden Winners and Pro. Here at The Motley Fool we believe that considering a diverse range of insights makes us better investors.