Intelligent Design

John McMillen | Portfolio Manager

Learn what matters - and what doesn't - when building a sound investment strategy.

The Dangers of Style Drift

July 2008

Mutual funds are classified based on the type of investments they hold – large or small, growth or value, foreign or domestic, etc. Because all such market segments will move in and out of favor over time, and it is impossible to tell when this will happen, creating a well-diversified portfolio is of paramount importance.

As numerous studies have shown, a portfolio’s asset allocation will account for over 90% of its return. It is therefore vitally important for investors to be able to control this single factor if they wish to have any reasonable control over the portfolio’s performance characteristics.

While mutual funds in theory make great tools for creating a well-diversified portfolio, retail mutual funds often engage in a practice known as “style drift” that can make it very hard to create a precisely allocated portfolio. Style drift occurs when a fund’s exposure to its stated investment objective changes, such as when a fund that has an objective stated as “Large Growth” begins to shift a significant portion over to, say, Large Value.

There are many reasons why this might occur, but the most common is when a fund’s investment style cycles out of favor and the fund manager starts feeling pressure to boost returns. This happened with many value funds in the late 1990s, when value stocks were posting flat returns while growth stocks soared to the tune of 30% annually. Many value managers began shifting their assets to growth stocks during that time in hopes of joining the party.

This creates a real problem for investors, because if your funds are not adhering to their investment objectives, then how do you know what you’re really invested in?

For example, the table below shows two funds that have experienced style drift over the past 3-years: 

Though both funds clearly display “value” in their names, an investor looking for value exposure may be surprised to know both were actually considered “core” (a sort of middle ground between value and growth) holdings at the start of the analysis. The Calvert Small Cap Value then moved to value, back to core, and is now more of a growth holding than value. The AIM Large Cap Basic Value started as a core holding, moved toward growth and now is where it should have been based on its stated investment objective: value.

It is not difficult to imagine how holding these two investments would cause a portfolio to deviate from its strategic asset allocation. Because these changes are rarely, if ever, announced, it will almost certainly lead to unintended risks.

Though there are many justifications given by fund managers on why they engage in style drift, none supersede the importance of maintaining a precisely diversified portfolio – virtually an impossible task while style drift is occurring. This is why we advocate the use of institutional, asset-class funds and certain Exchange Traded Funds for portfolio construction. Such funds track their targeted asset classes at all times; that means no style drift and no hidden surprises. 

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