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Scottish Mortgage or Fundsmith Equity: Which is best to back from here?

16 December 2022

Both portfolios have soared over the past decade, but have struggled in 2022 now that the era of free cash has ended.

By Tom Aylott,

Reporter, Trustnet

Scottish Mortgage and Fundsmith Equity have been two of the best performers over the past decade, with their growth-heavy strategies perfectly positioned to exploit the era of free cash in different ways.

The former took an all-out growth approach, buying companies that could triple in size in a matter of years. This strategy worked as global economic growth stagnated and low interest rates meant that the opportunity cost of tying up cash in these potentially long-term investments was minimal.

Fundsmith Equity meanwhile looks to buy dependable companies that will be around for years to come. It aims to buy businesses with strong brands and that have material and tangible advantages over their rivals. This worked as investors moved away from very low (and in some cases negative) yielding bonds

Both strategies worked in the era of low interest rates and ultra-loose monetary policy, making more than double the returns of their respective peer groups: Scottish Mortgage was up 461.3% and Fundsmith Equity leapt 341.1% over the past 10 years.

Total return of funds vs sectors over the past 10 years

Source: FE Analytics

However, with high inflation and interest rates dragging the decade’s biggest winners down and bringing both growth styles of investing into question.

This year has been tough for both as a result, with Fundsmith Equity down 13.5% throughout the course of the year while Scottish Mortgage has suffered a far worse fate, dropping 42.1% so far in 2022. Below, Trustnet asks experts which portfolio investors will want exposure to moving forward.

Total return of funds in 2022

Source: FE Analytics

Juliet Schooling Latter, research director at Chelsea Financial Services, said that it is worth holding both, but a higher allocation to Fundsmith Equity would be more advantageous over the short-term.

Scottish Mortgage could bounce back if inflation and interest rates drop back down to normal levels, but Fundsmith Equity should be more resilient in a recession.

Schooling Latter said: “If you think inflation is going to roll over, then you'd want to invest in Scottish Mortgage and enjoy its go-go secular growth story.

“If you think inflation will only come off a bit and remain higher than target for longer and that we'll get a reasonably hard recession, then you'd back Fundsmith Equity – its holdings have pricing power and can compound.”

Indeed, Ben Yearsley, director of Shore Financial Planning, also opted for Fundsmith Equity for similar reasons.

Although Tom Slater’s Scottish Mortgage investment trust may have soared in the growth-oriented markets of the past decade, Terry Smith’s quality-growth assets may provide more safety in challenging economic environments.

Yearsley said: “All-out growth was the place to be for most the past decade when funding costs were zero, but with more normalised markets it seems a stretch to see those type of companies prospering in large numbers.

“There is still a place for higher growth in portfolios but I think quality or defensive growth is more suitable to a wider group of people.”

Crucially, Fundsmith Equity’s holdings are more likely to generate a positive cashflow throughout a recession, meaning the fund’s ability to pay dividends is more secure.

This could be an important factor for investors who rely on income from their assets, particularly during the cost-of-living crisis.

Peter Walls, manager of Unicorn Mastertrust, said that he’d also favour Fundsmith Equity because its future performance will be driven by the 29 holdings within its existing portfolio.

Contrastingly, Scottish Mortgage has upped its gearing to 17% in order to support the assets it holds though volatile market conditions.

This could “introduce an additional element of risk which would be difficult to tolerate if markets took another downturn,” according to Walls.

He said: “While some of these companies may well become the disruptive market leaders of the future the current environment doesn't appear to be particularly conducive to realisations and some companies may need further capital.”

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Data provided by FE fundinfo. Care has been taken to ensure that the information is correct, but FE fundinfo neither warrants, represents nor guarantees the contents of information, nor does it accept any responsibility for errors, inaccuracies, omissions or any inconsistencies herein. Past performance does not predict future performance, it should not be the main or sole reason for making an investment decision. The value of investments and any income from them can fall as well as rise.