Asset allocation is a cornerstone of successful investing.
As the name indicates, it involves investing one’s capital among different asset classes and investment styles. You want an allocation that best meets your objectives, including expected returns and risk. Diversification and inter-asset correlations are key to success. However, if you allocate incorrrectly, you reduce the probability of achieving your investment goals.
So how does investment style drift figure into this?
Investment Style
Mutual funds should adhere to their stated investment style.
The stated style is disclosed in the prospectus.
The name of the fund itself should also indicate the investment style.
For example, the Fidelity Japan Fund (symbol: FJPNX) invests in Japanese securities. The Oppenheimer Emerging Markets Local Debt C (OEMCX) invests in fixed income instruments of issuers located in emerging markets.
Style Drift
Investment style drift occurs when funds shift from their stated investment objectives.
The shift can be unintentional or intentional.
Unintentional Shifts
An unintentional shift can occur without any physical changes in a fund’s portfolio.
For example, a small-cap fund holds shares of companies that have relatively low levels of market capitalization. Over time, some of these companies grow and become mid-cap or large-cap in size. Think of companies such as Microsoft and Google. They went from being small firms at inception to corporate behemoths today.
The same can be seen as growth companies mature. Revenues and earnings growth slows. As internal growth slows, these maturing companies begin to issue dividends. Before long, they morph into value companies. At one point in time, companies like Pfizer and General Electric were strong growth stocks. Now they are both value plays.
Companies can shift the other direction too. If you want a great example of changes in multiple characteristics, check out the rise and fall of Nortel.
And some companies are still in transition. Microsoft is included in many growth mutual funds. But I also see Microsoft in more than a few value funds.
If fund managers are not careful, they can find their style has drifted without any action on their part.
Intentional Shifts
A manager can manipulate his portfolio to intentionally deviate from the fund’s stated style.
Why?
The main reason is that fund performance is compared against the fund’s peer group and benchmarks. Relatively strong performance means more new investors and better fees for the fund managers.
Some managers will increase their portfolio risk in the hope of attaining greater returns. Or during bear markets, some managers will move from growth stocks (if that is the style) into value and/or defensive stocks to try and minimize the damage from a down market.
Same with bond funds. If interest rates are rising, long-term bond fund managers may try to shorten the duration of their bonds. If rates are falling, short-term bong funds may try to increase their durations.
The 80% Rule
Securities commissions often require some truth in advertising. The so-called “name rule” tries to ensure that fund names match the actual investments owned. In our examples above, you would expect the Fidelity Japan Fund to hold Japanese equities. And the Oppenheimer Emerging Markets Local Debt C to own emerging market debt instruments.
In the U.S., funds need to invest at least 80% of fund assets according to the stated style. Many other jurisdictions have similar requirements.
But that leaves 20% of a fund’s assets that can be invested outside the stated objectives, albeit subject to certain limitations. And that 20% can have an impact on the overall performance and style of the fund.
Picture a typical value fund. It probably has about 25-30% of its assets in its top 10 holdings. With 20% freedom to deviate, the fund could almost equal its top 10 holdings with investments in a completely different style.
Although a fund is required to stick to its style, there is potential for serious modifications within the actual holdings.
I suggest you review the rules in your jurisdiction to see how closely a fund must adhere to its stated style. The less the requirement, the greater the probability of style drift.
Why is this Important?
Ensuring your funds adhere to their stated style is important for two main reasons.
One, investors choose fund styles that meet their risk tolerances.
Conservative equity investors likely prefer funds such as: blue chip; large-cap, value, balanced, blended. They probably avoid small-cap or growth funds that have greater risk. But if a value fund exhibits style drift and starts accumulating growth stocks, its portfolio risk may increase to unacceptable levels for the low-risk investor.
Of course, unless the investor is aware that the fund’s style has changed, he will not realize his portfolio risk-return ratio has shifted.
Two, investors typically diversify their portfolios through asset allocation by purchasing funds in different investment styles and asset classes.
However, if one or more funds exhibit style drift, the diversification impact may be less than anticipated.
For example, you want exposure to to both growth and value stocks. You put 50% of your capital into Meteor Growth Fund and 50% in Slow and Steady Value Fund.
Initially the funds strictly adhere to their stated styles. But over time, some of Meteor’s high flying growth stocks mature begin to mature and become value plays. The economy has slowed and growth stocks are not expected to do well. Meteor’s manager decides not to sell these maturing growth stocks.
Further, given the economic forecast, the fund manager shifts a portion of his capital into value companies. Not enough to run afoul of the securities’ commission, but enough to have an impact on fund performance.
Without realizing it, your growth fund has shifted into more of a value fund than growth. Probably not 100% value, but maybe 50-60%. As a result, your asset allocation of 50% value and 50% growth is now 75% value and only 25% growth.
Not what you wanted and, as we will see when we discuss asset allocation, something that can impair your long-term portfolio performance.
When considering funds for your investment portfolio, do not rely solely on fund names or stated investment styles. Review actual holdings to ensure the fund reflects its stated style. Over time, for funds that you own, review fund holdings as part of your periodic review process. Very important to ensure your desired asset allocation remains accurate.
