Step 6: Style Drifters

Style Drifters
Comprehend active management style drift


Style Drifters






6.1

Introduction

Style drift happens when an active manager drifts from a specific style, asset class, or index that is described as the investment purpose of a portfolio or mutual fund. For example, a manager may drift from small cap value to small cap growth.  This is a substantial problem if you have carefully determined your Risk Capacity™ and matched it to a Risk Exposure.  

Hypothetically, you may be intentionally invested in a growth fund. Then unbeknownst to you, your active manager takes 30% of your Large Cap Stock fund and puts it in cash and bonds. This changes your growth fund to a balanced fund, changing the risk exposure, return, and time horizon of your investment. 

To avoid style drift, it is best to implement your asset allocation with "pure style" index funds. Index funds are invested using clearly defined rules of ownership.  Forty percent of the time, actively managed funds follow a manager's drift to a market that the manager thinks will keep his shareholders happy and save his own hide. Unfortunately, the shareholders suffer in the long run. As we have seen in previous steps, this predicting or chasing of returns has resulted in "below market" performance.
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Quotes


Ron Surz "Style drift is a serious problem for [investors] because it distorts asset allocation and undermines performance when styles rotate. Value managers who have drifted over the past three years [1998-2000] toward more favored growth stocks are regretting those moves, but not as much as their [investors]."
Ron Surz, President, PPCA Inc., Get the Drift, 2001
Rosanne Pane ''If a fund is drifting to a style that is dramatically different, your potential returns, volatility, and risk are going to change.''  
Rosanne Pane, Director, S&P Fund Services Group, Spotting 'Style Creep', When a fund starts to wander, returns can suffer, BusinessWeek Online
Craig Israelsen "One thing is clear: Style drift happens to a sizable percentage of mutual funds...For [investors or] planners seeking to create portfolios tapping into consistently different equity styles, style drift presents a significant concern."
Craig L. Israelsen, Ph.D, Drift Happens, Financial Planning Interactive, Nov, 1999
Robert Zutz "The SEC deems it a fraud if performance results are compared to an inappropriate index, without disclosing the material differences between the index and the accounts under management."
Robert J. Zutz, "Compliance Review", Schwab Institutional, Vol 10, Issue 8, Aug., 2001 [IFA comment: Any investment different from the appropriate index will get different returns. Technically speaking, the comparison of any active manager to any index is inappropriate, due to style drift]
Bob Stansky "How do you beat the S&P 500? You beat it by overweighting some groups, underweighting others, and by owning stocks that aren't in the S&P. [i.e. style drift]... Sometimes I think if people knew how risky I was acting in the portfolio [Fidelity Magellan] they'd really be surprised. Just go back a bit -- I made AOL very big; I made Yahoo very big. I'm not afraid to make any bet."
Bob Stansky, Manager Fidelity Magellan Fund, Inside the world's largest fund, by Jason Zweig, CNN/Money, 4/15/2002
FER "To better communicate the sources of risk associated with mutual fund investments, fund managers should provide estimates of the principal risk factors that are likely to influence fund returns in the future. Specifically, fund managers should describe and quantify the expected relationship between their fund's future returns and relevant security market indexes as well as the likely extent of divergence [style drift] of their returns from such indexes and the probable sources of such divergence. In subsequent periods, actual fund returns should be compared with the portfolio of market indexes previously selected by a fund."


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