Style Drift

A hidden risk:

How would you feel if you spent a tremendous amount of time to come up with the best investment allocation for you to later find out that you didn’t actually own what you thought you did? Unfortunately for investors who use actively managed funds, this is a common occurrence.

Another major contributor to poor investment results is style drift. Style drift is the divergence of a mutual fund from its stated investment style or objective. Style drift introduces needless uncertainty and often comes from managers chasing yesterday’s winners or betting on who they think will be tomorrow’s winners.

Active managers are often lured into changing their investment style if their stated theme is underperforming. Something always outperforms and something always underperforms. Since you don’t know in advance what will outperform, style drift can be dangerous. When your growth manager looks like your value manager and your large cap manager looks like your small cap manager, you are exposing yourself to unnecessary risk.

Many investors build portfolios comprised of different types of asset classes. Portfolios built of actively managed funds are subject to style drift from each of the component funds. Because of this, it is impossible to know exactly what you own at any given point in time. Often, investors are less diversified than they think and therefore subject to more risk than they think.

Managers of different styles tend to converge as bubbles build. When the bubbles finally burst, investors find out they weren’t as diversified as they thought they were.

Academic studies have shown that certain types of stocks outperform others over the long run. Although the outperformance does not show up like clockwork, it makes sense to build an investment strategy that takes advantage of these long term return premiums. Though you will not outperform every single year, the outperformance will be apparent over time.

Style drift, whether intentional or unintentional, is dangerous b/c it alters the underlying foundation of your investment strategy. Plus, trying to pick which theme will outperform next is just as unpredictable as picking which stock will outperform.

The surest way to avoid style drift is to use index funds. Index funds operate under a predefined and predicable set of rules. The use of index funds is the most reliable way to know what you actually own. Portfolios constructed of index funds gives you the best chance of owning all the parts of the marketplace that you desire at all times. Since you don’t know what will be tomorrow’s outperformer, owning everything ensures you will always participate in the next winner.

Investing in portfolios of index funds helps avoid style drift and all the problems (risks) associated with it. Investors who use index funds understand that they will always own winners and losers. This simple fact makes it more palatable to own a particular fund when that same sector is down. This is not true for investors of actively managed funds who are likely to sell a particular fund when it underperforms its “stated” benchmark.

Style drift only adds unnecessary confusion and uncertainty to investing.