Style Drift on Steroids

Normally, style drift refers to something like a value fund that dabbles in growth stocks or a large cap fund that drifts into small cap stocks. An article in the Wall Street Journal on May 2, 2013, "Bond Funds Running Low on…Bonds," puts a whole new spin on style drift.

Faced with very low bond yields, some active bond fund managers have resorted to buying stocks. According to Professor Russ Wermers of the University of Maryland, "When bond-fund managers buy stocks, they're reaching for yield in the form of dividends."1 However, high-dividend stocks are not a free lunch. An increase in yield always comes with an increase in risk, and dividend-paying stocks are far riskier than bonds.

According to Morningstar, 352 mutual funds classified as bond funds held stocks at the end of the first quarter of 2013. This represents a 13% increase over 312 as of year-end 2012 and a 24% increase over 283 at the end of the first quarter of 2012. A somewhat extreme example is the Forward Income Builder Fund, which had no allocation to stocks in mid-2012 but now has just under half of its assets in stocks, according to Morningstar.

One of the consequences of this style drift is that the 2013 reported returns for these funds exceeded their prospectus benchmarks, which are usually pure bond indexes. This can lead some naïve investors to believe that active managers possess some sort of advantage during low interest rate periods. However, there is no evidence that the bond market suddenly became inefficient. On the contrary, just like stock traders, bond traders turn over every stone, looking for mispriced bonds.

An appropriate use of bonds in a portfolio is to dampen the volatility of the equities, where the portfolio's risk should be taken. When investors access bonds through low-cost index funds, they do not need to be concerned about style drift into stocks.

Step 6Style Drifters