Gallery:Step 6|Step 6: Style Drifters

Style Drift and the Fama-French Risk Factors

Gallery:Step 6|Step 6: Style Drifters

Fama and French identified risk factors in 1992 that highly correlate with long-term historical returns, namely company size and value orientation. Style drift between these two factors for two periods of approximately fifteen years can be seen in the Figure below. On the horizontal axis, Value is a high Book-to-Market ratio (BtM) and Growth is a small BtM. On the vertical axis, Small and Large Cap are companies with small and large market capitalization, respectively. The numbers on the axes are measures of market exposure to each of these asset classes. The (0,0) point (the crossing of the axes) essentially represents the entire market. It reflects all of the stocks in the CRSP database and is the reference for the other measurements.

The orange points reflect the average exposure of the funds during the period between January 1976 and December 1989. The red points reflect average exposure during the period between January 1990 and December 2004. Note how far some funds moved from their starting point. This movement reflects Style Drift and is often an unannounced change in investment objectives. Other funds barely moved. It should be noted that the data fails to reveal the many additional shifts in positions that these funds made within each of the years depicted. These additional shifts drive up trading costs, generate higher taxes, alter risk, and will likely result in lower returns.

One of the reasons it is so dangerous to style drift is because styles are as unpredictable as stocks, times, or managers. Take a look at how the style of the year changes over time in the dynamic table below. Just follow the green Emerging Markets which mostly alternates between the top and bottom of the pack. Can you pick the next winning style? It is no wonder that both professional and amateur investors are whipsawed into investing in different styles. But investors who hold onto diversified portfolios of index funds obtain the returns of all the asset classes that are appropriate for them over time. This approach has the highest probability of allowing investors to meet their goals.