Terry Smith: This Passive-Led Momentum Market Will End Badly

Investor enthusiasm for artificial intelligence and passive investing has pushed momentum to levels rarely seen in modern markets, creating an increasingly difficult environment for managers focused on profitability, returns on capital, and valuation.

For Terry Smith, the divergence has become impossible to ignore. Fundsmith Equity Fund fell 2.9% during the first half of 2026, trailing its primary equity comparator by 14.1 percentage points. Smith argues that the underlying market structure is increasingly responsible for the disconnect between business fundamentals and share prices.

“The backdrop to this continues to be 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.”

The concern is not simply that momentum is outperforming. Smith notes that its relative performance has reached a 30-year high, exceeding even the extremes seen immediately before the Dotcom bubble burst.

“It is at a 30 year high and more extreme than in late 1999 just before the Dotcom bubble burst.”

That environment has produced extraordinary price movements in some of the market’s largest companies. Smith points to multibillion-dollar businesses experiencing dramatic overnight valuation changes, raising questions about how much current pricing reflects fundamental analysis.

The potential consequences of a reversal are significant.

“Next time round, it would not surprise me if it accomplished this in five days.”

Despite these concerns, Smith is not abandoning Fundsmith’s focus on high-quality companies. Instead, the firm is adapting its process to recognize that momentum and fund flows can remain powerful for longer than traditional valuation disciplines might anticipate.

“We have no intention of investing in anything other than good businesses whose characteristics are such that they should compound in value over time better than the market average and at reasonable valuations as well as providing some fundamental support for the value of our investment in the event of a market dislocation.”

However, the portfolio will become more active, with greater consideration given to both fundamental and share-price momentum. Smith acknowledges that buying quality businesses after temporary setbacks has become increasingly dangerous when passive flows amplify downward price movements.

The broader message is that investors may be underestimating the risks created by market concentration, AI enthusiasm, and momentum-driven capital flows.

“I profess no insight into how or when this passive-led momentum market will end, other than to say badly.”

For investors focused on fundamentals, patience is being severely tested. Yet Smith remains committed to owning profitable companies capable of generating strong returns on capital and sustainable cash flow growth.

“But we do know that trees do not grow to the sky.”

Full letter here:

Fundsmith Semi-Annual Letter 2026