Active vs Passive Investing UK 2026: Has the Debate Finally Been Settled?

Earlier this month, Terry Smith published his semi-annual letter to Fundsmith investors. Smith is probably the most well-known active fund manager in the UK — the kind of figure whose annual letters get read carefully by people who invest seriously and shared widely among those who follow markets. For fifteen years he ran Fundsmith Equity on three rules: buy good companies, do not overpay, do nothing. The "do nothing" part was the one people quoted most. It was his version of the Buffett principle — find great businesses and hold them for decades while everyone else churned their portfolios chasing short-term gains.

The letter revealed he had overhauled 51% of the portfolio in six months. In a fund that typically turns over less than 10% of its holdings in an entire year, that is an extraordinary number. And the reason he gave was the thing that makes this worth writing about: he blamed passive investing.

Fundsmith Equity fell 2.9% in the first half of 2026. The MSCI World — a global equity index that passive funds track — gained 11.2% in sterling terms over the same period. The gap was 14 percentage points in six months. Over the past five years, Fundsmith has returned about 10% while the global index returned over 80%. The fund has shrunk from £29 billion at its peak to around £12 billion today as investors moved their money elsewhere — mostly, it seems, into passive alternatives.

This is not just a story about one fund manager having a bad run. It is a story about a fundamental shift in how markets work — one that has real implications for where you put your money. I want to explain it clearly, because the passive versus active debate is no longer just academic. Something genuinely structural has changed.

The Basic Case for Passive — Which Was Already Strong

Before getting into the Terry Smith story, it is worth being clear on why passive investing won the argument on the numbers even before the structural shift he is describing.

An index fund does not try to pick winners. It simply buys every stock in an index — say, the MSCI World — in proportion to its size. When a company gets bigger, it gets a larger weighting automatically. When it shrinks or is removed from the index, the fund sells it. No judgment, no research, no salary for a fund manager deciding what to buy. The annual fee is typically 0.1-0.2%.

An active fund pays a manager to make those judgments. The manager decides which stocks to buy, when to buy them, and when to sell. For this service, the fund charges typically 0.75-1.5% per year. In exchange for that additional fee, the manager needs to outperform the index by enough to cover their cost — and then some — to justify the choice over a passive alternative.

The data on how often active managers achieve this is not flattering. SPIVA — a widely cited analysis by S&P Global — consistently finds that around 80-90% of active equity fund managers underperform their benchmark index over 10 years, after fees. Over 20 years, the proportion that underperform is even higher. This is not because the managers are incompetent. It is largely because the fees are a permanent headwind that compounds against them over time. A 1% annual fee on a portfolio growing at 7% does not cost 1% of returns — it costs significantly more in compounding terms over decades.

Fundsmith was an exception to this pattern — or appeared to be. In its first decade from 2010 to 2020, the fund returned 458%, more than twice the global index return. Smith's focus on high-quality companies with strong returns on capital and predictable cash flows genuinely worked. The problem is what happened next.

What Smith Says Has Changed — and Why It Matters

Passive funds now hold more than 50% of all US equity assets. That is a genuinely landmark number — for the first time in history, more than half of the money in the world's largest stock market is invested without any reference to the underlying business quality, valuation, or prospects of the companies being bought.

Smith's argument — and it is a serious one, not sour grapes — is that this has fundamentally changed how prices are set. In a market where active managers dominated, prices reflected the collective judgments of thousands of analysts and portfolio managers deciding what businesses were worth. Good companies at reasonable prices got bought. Overpriced companies got sold. The mechanism was imperfect, but it broadly connected share prices to business fundamentals.

In a market where passive funds dominate, money flows into stocks mechanically — based on index weighting, not business quality. A company that is already large gets more money automatically every time someone opens a pension and directs contributions to an index fund, regardless of whether that company is cheap or expensive, growing or stagnating. This creates what Smith calls a self-reinforcing feedback loop: large companies attract passive money, which makes them larger, which attracts more passive money.

The practical effect is that momentum has replaced fundamentals as the primary driver of short-term price movements. The stocks already at the top of the index get more money automatically. The quality companies that Smith built Fundsmith around — defensive consumer businesses like Unilever, Diageo, Brown-Forman — do not benefit from this automatic flow. They are mid-size or below in a market dominated by technology mega-caps, and passive flows reinforce the mega-caps regardless of valuation.

Smith's Response — And What It Tells You

His response to this environment was to abandon the "do nothing" rule he had championed for fifteen years. He opened 12 new positions in six months — including Mastercard, TSMC, GE Vernova, and Netflix — and exited long-held positions including Unilever, Novo Nordisk, Nike, and Zoetis. Portfolio turnover hit 51.8% in six months. For context, in most previous years it was under 10%.

I find this genuinely fascinating, and slightly uncomfortable, to observe. Smith is an intelligent man who has thought carefully about markets for a long time. When someone of his calibre abandons a core principle they have held for fifteen years and publicly attributes it to a structural change in how markets work, it is worth taking seriously.

But it is also worth noting the other reading. Fundsmith underperformed the index badly for five straight years. The fund has lost more than half its assets under management. At what point does a strategic pivot reflect a genuine insight about market structure, and at what point does it reflect a manager adapting their story to explain underperformance? Fund analysts quoted in the coverage of the letter ranged from sympathy to scepticism. That ambiguity is real and I do not think it resolves cleanly.

What is not ambiguous is the performance record over five years. A global index fund in the same period returned over 80%. Fundsmith returned about 10%. That gap exists regardless of how you feel about the structural argument.

What This Means for Someone Investing Their Pension or ISA

If you are a regular person investing £300 a month into your pension or ISA, does any of this change what you should do? My honest view is: probably not much, but with one nuance worth understanding.

The case for a low-cost global index fund as the core of a long-term investment portfolio remains strong. Fees are low. Diversification is automatic. You are not betting on a single manager's skill or judgment. Over long periods, the evidence consistently supports index investing as the rational default for most people.

The nuance is that the Terry Smith story illustrates something genuinely interesting about what passive dominance does to markets. When 50%+ of money flows mechanically into stocks based on index weighting, the largest stocks in the index — mostly US technology companies — get a permanent, automatic tailwind. A global index fund today is roughly 70% US equities, and within that a significant chunk is concentrated in a handful of mega-cap technology businesses. You are not getting as diversified an exposure as the word "global" suggests.

This is not an argument against index funds — it is an argument for understanding what you are actually buying. A Vanguard FTSE Global All Cap or iShares MSCI World is not equally distributed across the world's economies. It is heavily weighted toward US technology stocks at historically high valuations. That is fine if you believe those valuations are justified. It is worth knowing if you do not.

Active Funds — When Do They Make Sense?

I am not going to give you the standard answer here which is "active can work in inefficient markets like small caps or emerging markets." That is technically true but it is also the kind of thing that sounds reasonable until you look at the actual data for small cap and emerging market active funds, which is only marginally better than large cap active funds and still mostly terrible after fees.

The honest answer is that active funds make sense in a portfolio when you have a specific, well-reasoned view about why a particular manager adds value that an index cannot replicate — and when you are genuinely prepared to hold through periods of underperformance without second-guessing yourself. Most people say they can do the second part and discover they cannot when it actually happens. Fundsmith's assets shrinking from £29 billion to £12 billion is partly the story of investors who said they were long-term but bailed after five bad years.

My view — and this is just my view, not advice — is that for most people building a pension or ISA, an index fund should be the core. Not because active management is always wrong, but because identifying the active managers who will genuinely outperform in advance is genuinely hard, and the fee drag while you find out is permanent. If you want active exposure, keeping it deliberately small — maybe 10-20% of the portfolio — and choosing it carefully is a reasonable approach. Paying 1% per year for active management requires that manager to outperform the index by 1% annually before you are even level with a cheap tracker. Over 20 years at 7% growth, the compounding cost of that difference is not trivial.