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 Israelsen, Drift Happens, Financial Planning Interactive, Nov. 1999

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, 2001

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, August 2001

Introduction

When you buy a box of Corn Flakes, you expect corn flakes in your cereal bowl. It is a safe and reasonable assumption that you are getting what you think you are buying. You know you are not buying granola or oatmeal. The name on the box is true to the box's contents.

This is not the case with active fund managers who engage in style drifting. A style can refer to the asset class, index, market segment, or classification that a mutual fund states as its objective, described as the fund's investment purpose. When active managers style drift, they do not stay true to the type or name of a fund in which your money is invested. They do this by drifting from a fund's stated style into another style that no longer represents the fund's objective. For example, 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 the composition of your growth fund by altering the risk exposure, return and time horizon of your investment. The fund no longer matches its name or style. In passive investing with index funds, the name of a fund corresponds to the contents of that fund, described as "style pure."

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Style Drift Alters Risk Exposure

There are different risk characteristics among the many categories of investment styles. An index or asset class is designed to carry a particular risk exposure, a key identifying factor for any fund. Market capitalization styles include large cap, mid cap, small cap, and micro cap stocks. A growth style commonly pertains to stocks that have experienced rapid growth in earnings, sales or return on equity, as well as low book-to-market ratios (BtMs). A value style, on the other hand, refers to stocks that have carried low price to earnings ratios, high BtMs, and are often labeled as "distressed." Beyond these broad descriptions, funds are sorted into categories such as domestic, international, emerging markets, select technology, health care, energy, and others.

No industry-wide standards exist for defining these terms, making it hard for proper benchmarks to define what constitutes value, growth, large cap, small cap, international, or emerging market stocks. To make matters even more difficult, carefully crafted fund prospectuses give active fund managers significant leeway to deviate from their fund's stated investment style. As a result, companies with divergent risk and return characteristics are often lumped together into the same style.

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Style Picking

When active fund managers assume their fund's investing style will underperform, they often abandon their stated strategies to chase the returns of other investment styles. For example, when small company fund managers project a slump in small company stocks, they may start buying large cap stocks in hopes of beating small cap benchmarks. More than half of actively managed funds utilize investments that do not reflect their stated objectives.

Mutual fund companies have been required to change the description of their funds due to style drift. In November 1998, Boston Globe columnists Steven Syre and Steve Bailey exposed Fidelity's Emerging Growth Fund for including giant companies like Microsoft and MCI WorldCom.1 The SEC compelled Fidelity to change the fund's name to the Aggressive Growth Fund, along with the prospectus's spurious claim that the fund focused on smaller stocks.

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The Elements of Style

The next three charts reveal the difficulty of identifying a winning style in advance. Figure 6-1 displays the Annual Returns of 13 Asset Class Indexes for the 20-year period from 1994 through 2013 and shows that high and low returns of key market indexes follow no discernible pattern. Figures 6-2 and 6-3 show the same is true for the historical returns of various countries and industrial sectors. Investors who attempt to overweight or underweight specific styles based on speculation about future market movement undermine their ability to achieve the risk-adjusted returns that result from maintaining a proper asset allocation made up of a consistent blend of investment styles.

Figure 6-1

Figure 6-2

Figure 6-3

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Style Drifters

In the 1980s, Fidelity’s Magellan fund and its then-manager Peter Lynch were touted for outpacing the S&P 500 Index. However, Lynch had achieved his big returns by concentrating a large portion of the fund’s holdings in small cap stocks. In so doing, his investors were unwittingly exposed to a higher level of volatility that may not have been in line with their investment objectives. Magellan’s returns looked good when measured against the S&P 500 Index, an inappropriate benchmark that included no small cap stocks. The appropriate benchmark for Magellan would have been a blended index of both small cap and large cap equities.

In the mid-1990s, Jeffrey Vinik took over the fund’s helm. He made a famous market call in November 1995, bailing out of $10 billion worth of technology stocks. He put a lot of that money into cash and bonds. During the next six months, Magellan’s value barely moved, as the broad market skyrocketed. As a result, investors suffered from lower returns and higher capital gains taxes.

Figure 6-4 illustrates the style drift of Fidelity’s Magellan fund from January 1, 1982. The scale on the vertical axis represents the fund’s relative exposure to different styles, and the different colors represent different investing styles. In 1995, the fund looked like a large value fund (green), but by 2000 and 2009, it would have been seen as a large growth fund (blue). This shift from large value to large growth caused the fund’s investors to unknowingly be exposed to risks substantially different from what they might have planned.

Figure 6-4

To expand the analysis, let’s look at two additional mutual funds whose exposure to different styles drifted over time. Figure 6-5 displays the style drift of the Vanguard Explorer Fund, which is designated by Vanguard as a small growth fund. Note that the tan zone is a small growth index, and the brown is a small value index. The fund experienced a spike in exposure to small value in the early 1990’s, shifting it away from its original allocation and altering its risk exposure for its investors.

Figure 6-5

Similarly, Figure 6-6 illustrates the style drift of the Growth Fund of America, which is designated as a large growth fund. Note the lack of style consistency as the various indexes in the fund seem to move up and down like a roller coaster. Both of these funds did not stay true to their identity.

Figure 6-6

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Style Purity

There is a stark contrast between the loose style definitions held by actively managed mutual funds and the strict definitions used by indexers. Indexes are created according to specific criteria, allowing for accurate tracking and prevention of style drift. Figure 6-7 shows the style purity of an S&P 500 Index Fund over a 32-year period. In contrast to the drift of the three previous funds, the index maintained relatively constant exposure to large growth and large value equities over the entire period.

Figure 6-7

The Standard & Poor Indices versus Active Funds Scorecard2 (SPIVA®) is a report that provides information on the consistency or "persistence" of funds staying true to their styles. Data from the Year-End 2012 report is shown in Figure 6-8, revealing the inconsistency or lack of persistence in the list of funds from 2008 to 2012. Looking at the active domestic equity funds tracked by Standard and Poor’s, only 49.33% remained style consistent over the five-year period.

Investors should carefully review Morningstar data to determine if a fund has a history of adhering to its stated investment style. Because passively managed index funds adhere to their styles, they provide investors with consistent risk exposure and the assurance their funds will stay true to their purpose.

Figure 6-8

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Tactical Asset Allocation

Tactical asset allocation refers to the practice of changing the composition or style of a portfolio based on market conditions. An example would be selling a portion of the portfolio's bonds and buying stocks when the earnings yield on stocks has risen above a benchmark interest rate. Of course, the parties on the other side of these trades are well aware of these changed market conditions, so the prices paid and received by the tactical allocator are fair and impart no expectation of an additional risk-adjusted return. Figure 6-9 displays the results of a review of 24 mutual funds with a 20-year record based on tactical asset allocation as of December 31, 2013. As the chart shows, only two funds plot distinctly above the line of index portfolios. While 2 of 24 (8.3%) is rather dismal to begin with, the true percentage is much lower because we are only looking at funds that survived for the last 20 years. An investor who chose a tactical allocation fund 20 years ago had a very small chance of both keeping the same fund and beating a risk-appropriate allocation of index funds.

Figure 6-9

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Bottom Line

Wise investors avoid the pitfalls of style drift in two different ways. First, they resist the temptation to overweight or underweight asset classes that may be touted or spurned based on speculation or hype from so-called experts or the financial media at any particular time. Second, they steer clear of actively managed funds that are notorious for this style inconsistency as they also participate in this overweighting or underweighting behavior as they attempt to beat the market. Instead, wise investors avoid style drift by holding a consistent allocation of index funds appropriate to their risk capacity, allowing them the full benefits of style purity.

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Footnotes:
  • 1S&P Indices, Research and Design, "Standard and Poor's Indices Versus Active Funds Scorecard (SPIVA), Year-End 2010)," (2011).
  • 2Steve Bailey and Steven Syre, "Fidelity's bulking up on large-caps Emerging Growth fund especially relies on big stocks," Boston Globe (Boston, MA) Nov. 12, 1998.
  • 3S&P Indices, Research and Design, "Standard and Poor's Indices Versus Active Funds Scorecard (SPIVA), Year-End 2010)," (2011).
step 6style driftingstyle purestyleasset classindexmarket segmentbook-to-market ratiobtmsdomesticinternationalemerging marketsselect technologyhealth careenergyvaluegrowthlarge capsmall capemerging marketstandard and poor'ssteven syresteve baileysecboston globepeter lynchmagellan funds&p 500jeffrey vinikvanguard explorer fundgrowth fund of americastandard & poor indices versus active funds scorecardspivabondsstocksfair pricestyle purityrisk capacity

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