Value

Style Drift on Steroids

Value

In Step 6 of IFA’s 12-Step Recovery Program for Active Investors, we analyze the problem of style drift, the tendency of active managers to buy securities outside of their mandate. 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.

          In response to the current environment of 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.” As we noted in this article, 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, indicating that the trend is accelerating. 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 recently reported returns for these funds exceeded their prospectus benchmarks, which are usually pure bond indexes. This leads some observers to believe that active managers possess some sort of advantage in this era of ultra-low interest rates. IFA reminds investors that all of us are operating under the same conditions of repeated interventions by the Federal Reserve to keep interest rates low. The bond market did not suddenly become inefficient. If anything, it is even more efficient as bond traders turn over every stone, looking for mispriced bonds.

          While we may not have seen bond funds drift into stocks, we have definitely seen stock funds drift into bonds. The most notorious example is Peter Lynch's successor at the Fidelity Magellan fund, Jeff Vinik, who made an ill-fated decision in 1996 to put 30% of the fund's assets into bonds and cash. This caused two problems for Magellan's investors; they missed out on a subsequent gain that occurred in stocks, and they had to pay taxes on the capital gains distributions resulting from Vinik's sale of stocks. Interestingly, Vinik has been in the news lately with his announcement that he is closing his hedge fund, Vinik Asset Management, after losing 4.8% since the start of July 2012, compared with a 19% gain for the S&P 500. This announcement came on the heels of investors demanding to withdraw $1.5 billion from the $8 billion fund. The decline in the fund’s value was attributed to a large bet on gold mining stocks, which were hit hard by gold’s plunge in April 2013. 

          It is IFA’s opinion that the best use of bonds in a portfolio is to dampen the volatility of the equities, where the portfolio’s risk should be taken. As such, IFA continues to advise the use of high quality bonds with maturities of five years or less. Furthermore, the preferred way for most investors  to access bonds is through low-cost index funds where style drift into stocks simply does not happen.