Style Drift Can Hurt Mutual Fund Returns

By Jon Ogg AAA

Style drift is the tendency of an investment portfolio manager to alter an investment style over time. In practical terms, most investment strategies change and must adapt through time. In reality, however, style drift can become a significant risk for investors if a portfolio\'s focus changes too much.

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Primary Causes of Style Drift
Style drift can be the result of many things, but the most common reasons for a style drift include a change in the investment climate and attempts to chase investment returns.

The overall investment climates changes, otherwise we wouldn\'t have "bull markets" or "bear markets" to describe longer-term market trends. Many trends come into play over time and investment managers often get caught up in them. As a result, a manager may deviate from his or her default investment strategy and catch a great run in energy, IT or biotech stocks. They may also stick with this trend-following strategy for too long and allocate more and more assets toward it, perhaps believing that the style has become bulletproof. Unfortunately, almost all sectors and all market trends change over time and, if the changes to the portfolio have changed its risk profile, this could lead investors into more risk than they bargained for. (To learn more, read Rebalance Your Portfolio To Stay On Track.)

Intentional and Unintentional Style Drift
When investors sign up with a certain money manager because of his or her style, they expect that style to remain the focus. This doesn\'t mean that an unintended style drift can\'t come into play.

For example, many conventional investment philosophies dictate that no more than 10% of a portfolio should be allocated to any single holding. But what happens when a portfolio manager makes an incredible pick? Imagine that a portfolio manager in 1999 told clients he thinks this small outfit called Microsoft could have a real growth spurt from core software sales as households and many small businesses were increasing their PC purchasing into the 1990s. If the initial allocation started as 5%, even with the market volatility and risks seen in the early \'90s, the portfolio allocation could have grown to being 30% or more in four years and could have easily soared to more than 50% within seven years. This puts managers in a bind because they often have to tell clients that a large percentage of their holdings are now too much in a single stock, even if they feel there is still much more upside to come. (To learn more, read How Risky Is Your Portfolio?)

Having a significant portion of your portfolio allocated to a winning stock sounds great, but the flip side is that you might also be subjected to a manager that missed Microsoft and decides to allocate too much into what he thinks is the "the next Microsoft" so that the clients can see that gain. While this can work, it can also put an investor\'s assets at severe risk. Just think of all the dead software companies - they may have had great products and great promise, but they just didn\'t make the grade. (For more on this, check out Which Is Better: Dominance Or Innovation?)

Chasers and Underperformers
The problem is not only that style drift can alter a portfolio\'s path, but also that it can hurt investors in a manner that they weren\'t signing up for when they went with a manager and his style.

Unfortunately, many fund managers chase trends and end up venturing into the latest greatest strategy that may only have a temporary ride. In 1998 and 1999, all a portfolio had to do to chase the dotcom boom without investing in internet companies was to invest in companies that had not yet announced what their internet strategies were going to be. However, many started investing in these companies or the actual headline stocks after the fact. A general rule is if it is a "newest and latest" trend on a magazine cover, a lot of the good things have already occurred.

Perhaps the largest cause of style drift is underperformance. When an investment manager is lagging behind a target or when the portfolio is seeing losses, style drift becomes the easiest strategy. Pretend that your investment manager uses the S&P 500 as a benchmark. Suppose the portfolio is up only 3% when the S&P is up 16% - either the manager made some poor choices or left too much of the portfolio\'s assets in cash. The risk is that the manager will start to make larger and more focused and concentrated bets, rather than diversified longer-term planning. This situation is unfortunate, but when the pressure to perform becomes too great, the investment manager may be tempted to take larger and larger risks. (To learn more, read Assess Your Investment Manager and Why Fund Managers Risk Too Much.)

Margin and Style Drift
While some managers refuse to ever use margin because of the risk that large leveraged losses will occur, many other managers use margin from time to time, and some depend on it. If you invest with a money manager that uses leverage, you must assume that your gains can be above normal markets gains - and also that your losses can quickly get out of hand.

If you do not want the risks associated with margin and your manager\'s style drift suddenly leaves you with borrowing costs and more securities in an account than you could hold without margin, then you are experiencing the riskiest part of style drift. (To learn more, read the Margin Trading Tutorial.)

The Risks of No Style Drift
Excessive style drift can hurt investors, but there is a flip side to the issue: not having any style drift is risky too. It\'s easy to believe that a sector or a stock has become secular and will be solid for a generation, but what if you invested in only internet or even tech stocks in the mid-\'90s, but didn\'t get out because of a belief that even if these sectors are bubbling, the long-term trend is still secular? This means that the focus of the fund by policy has to stick with stocks in that sector, and it means that all of your exponential gains would have been wiped out for those who stuck with it after 1999 and 2000.

Even worse, imagine what can happen when a manager decides that the best thing to do is stick with a trend that goes against the expectations. This is when money managers can turn a large fortune into a small one.

Bottom Line
Style drift is a risk to investors. It can create more risk in a portfolio than an investor has signed up for. On the other hand, a portfolio with absolutely no style drift may not be the best choice either. Investment philosophies and goals should change through time for most investors, and it is probably safe to assume that some natural style drift may occur.

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