The fundamental challenge in asset management lies not in generating outperformance, but in proving that outperformance represents skill rather than statistical noise. Recent struggles at Fundsmith Equity, where celebrity manager Terry Smith has delivered four years of underperformance culminating in a devastating 10.3% monthly loss this past March, provide a compelling case study in this statistical reality.
The evidence shows that proving that a manager possesses genuine skill requires an almost impossibly long track record. For example, according to research by Brad Steiman at Dimensional Fund Advisors, for a fund manager generating a modest 2% annual outperformance with typical volatility, it would take 36 years of data to be 95% confident that their success isn't simply due to chance. (1) If that manager's alpha drops to just 1%, the required timeframe balloons to 144 years. Even a manager delivering substantial 4% annual alpha would need nine years to reach statistical significance.
This harsh mathematical reality was crystallized in groundbreaking research by Nobel laureates Eugene Fama and Kenneth French. Their comprehensive study of US mutual funds found that most fund outperformance was indistinguishable from pure luck. (2) Even more damning, they concluded it was "impossible to tell whether an active fund manager's stellar performance is due to skill or just sheer luck" for the vast majority of managers.
The Fundsmith case study
Terry Smith's trajectory illustrates these statistical principles in practice. Launched in November 2010, Fundsmith Equity outperformed the MSCI World Index in nine of its first eleven years through a simple philosophy of buying high-quality companies with strong brands, predictable cash flows, and sustainable competitive advantages. The fund's assets swelled to over £25 billion by 2021, cementing Smith's reputation as one of Britain's most successful managers.
Yet Fundsmith's 14-year track record, impressive as it appears to investors, remains statistically meaningless from an academic perspective. Smith could have been an exceptional stock-picker during those early years, or simply the beneficiary of market conditions that favored his investment style. The recent underperformance, with the fund delivering 8.98% returns against the MSCI World's 20.8% in 2024, doesn't necessarily indicate declining skill but rather the natural reversion to randomness that statistical theory predicts.
Smith's recent struggles with individual holdings further demonstrate how random market movements masquerade as investment errors. His decision to avoid NVIDIA, whose shares have soared over 2,000% since early 2023, appears to critics as a classic stockpicking blunder. However, from Smith's quality-focused framework, avoiding an unpredictable technology stock was entirely consistent with his stated approach. That this particular unpredictable stock became the market's biggest winner reveals nothing about Smith's analytical capabilities.
Similarly, his underweighting of Apple, where the fund holds just 1.4% compared to the stock's 6.6% weighting in the S&P 500, cost performance as Apple shares rose 23% in the first half of 2024. His concentration in Novo Nordisk, which Smith now accuses of snatching defeat from the jaws of victory in the weight-loss drug market, comprises 5.5% of the portfolio and has fallen over 52% in the past year. (3) These apparent missteps may simply reflect the unavoidable risks of running a concentrated portfolio.
Research by Hendrik Bessembinder has shown that market returns are driven by just 4% of stocks. (4) Missing these few mega-winners, or holding insufficient weightings, can destroy performance regardless of how skillfully a manager selects other holdings. Perhaps most revealing is Smith's complaint about currency headwinds, where pound appreciation hurt returns since most holdings are US companies. This inadvertently highlights how much fund performance depends on factors entirely outside managerial control.
Implications for investors
The statistical impossibility of distinguishing skill from luck over practical investment horizons creates profound challenges for investor decision-making. Survivorship bias compounds these difficulties, as we observe only successful managers while thousands who failed disappear through fund closures and mergers. According to Boston Consulting Group, only 37% of funds launched in 2013 still existed by 2023.
This dynamic creates destructive performance-chasing cycles. Assets poured into Fundsmith Equity as Smith's reputation grew, with many investors arriving precisely when recent underperformance began. Since mid-2022, the fund has experienced consistent net outflows, with £4.6 billion fleeing since 2024 and £1.5 billion withdrawn in the first half of 2025 alone, pushing assets under management below £20 billion.
The psychological challenge extends beyond mere performance measurement. Research from Morningstar demonstrates that even funds which ultimately outperformed over 15-year periods typically endured stretches of underperformance lasting 9 to 11 years. (5) Smith's remaining investors must maintain conviction that his quality-focused approach will reassert itself while colleagues in simple index funds watch portfolios compound without drama.
Smith's age, 72 and approaching typical retirement, adds succession uncertainty. The track record investors evaluate isn't merely an investment philosophy but Smith himself, creating additional key-person risk that index strategies avoid entirely.
The market's verdict
The cruel irony of active management lies in its opportunity cost. While Smith struggles to match market returns, those very returns remain available to any investor through global index funds at a fraction of active management fees. A simple passive strategy would have delivered exactly the performance Smith's investors are missing, without requiring faith through extended underperformance periods.
Smith's early success, viewed through statistical analysis, appears less like evidence of exceptional skill and more like a fortunate sequence of market conditions aligned with his investment style. His subsequent struggles don't necessarily represent declining ability but rather randomness reverting to its mean.
For investors seeking to identify skilled managers before their outperformance periods begin, the mathematics remain unforgiving. By the time sufficient data exists to prove genuine skill, decades will have passed and simpler alternatives will have compounded wealth more reliably.
The broader lesson transcends individual manager selection. In a field where the "Magnificent Seven" tech stocks can distort entire market narratives and Federal Reserve policy shifts redefine risk premiums overnight, the distinction between skill and luck may be fundamentally unknowable within practical investment timeframes. (6)
Terry Smith's story serves as a cautionary tale about the illusions embedded in active management. When markets reward specific approaches, we retrospectively attribute success to managerial genius rather than acknowledging the role of chance. The smartest investment decision often proves the simplest: accept market returns and focus resources on areas where skill can be more reliably identified and measured.
ROBIN POWELL is a freelance journalist and author and the Editor of The Evidence-Based Investor.
This article is produced by us for Financial Advisers who may choose to share it with their clients. Timeline Planning and Timeline Portfolios do not offer direct-to-consumer products.
References:
- https://www.ifa.com/articles/paradox-of-skill
- https://www.chicagobooth.edu/review/measuring-chance-0
- https://citywire.com/new-model-adviser/news/terry-smith-blames-novo-nordisk-and-weak-dollar-for-funds-straggling-performance/a2469624
- https://papers.ssrn.com/sol3/papers.cfm?abstract_id=3873010
- https://www.morningstar.com/financial-advisors/how-long-can-good-fund-underperform
- https://www.evidenceinvestor.com/post/why-is-terry-smith-struggling
