What Is Style Drift?

What Is Style Drift?

Style drift is the divergence of a fund from its investment style or objective. Style drift can result naturally from capital appreciation in one asset relative to others in a portfolio. It can also occur from a change in the fund’s management or a manager who begins to diverge from the portfolio's mandate.

Generally, a portfolio manager's commitment to managing a fund's assets according to its stated investment style over several years is positive investment quality. For obvious reasons, consistency in this particular area is preferable to style drift. Managers chasing performance have been known to use different strategies, which are often counterproductive and can change the risk-return profile of the fund for the investor.

Understanding Style Drift

Investing style drift can refer to a situation where a fund manager makes any investments outside of the fund's stated investment objective. Registered funds are under greater scrutiny for style drift than privately managed funds such as hedge funds. The Securities and Exchange Commission (SEC) has rules requiring that a fund invest 80% of its assets in investments suggested by the fund name. However, fund managers can invest the remaining portion at their discretion.

While a fund may have a clearly stated investment objective, some fund parameters may be extensive. For example, a stock fund or bond fund allows the manager to invest in the entire investable universe of stocks or bonds. When the allowable investments are broad, the portfolio has the flexibility for style drift within the legal constraints of the fund. In a stock fund, style drift can quickly occur when a fund’s stock investments increase across market cap thresholds. For example, a stock fund investing heavily in small-caps may see its portfolio drift into a mid-cap portfolio. If the fund’s only legal constraints are that it invests in stocks, then this style drift is compliant with its strategy. Under the same scenario, a stock fund manager may also see greater return opportunities in other areas of the equity market, which could cause him to deviate from an established style.

Some fund managers may use the fund's remaining 20%, which can be invested more flexibly, to make extreme investments outside of the fund’s primary objective. In some cases, this may be known as style drift investing since it deviates significantly from the main focus of the fund. Fund managers may use derivatives to hedge some of the risks of a fund for downside support. Fund managers may also hold significant amounts of cash in the discretionary portion of a fund for operational management.

Style Drift Due Diligence

Investors in regulated funds can rely on the SEC’s rules for some protection from style drift. Risks of style drift may be higher for alternative funds such as hedge funds. Standard investment due diligence can help an investor to identify style drift and understand the changing allocations of their investment fund. Holdings reports, asset mix breakdowns, sector breakdowns, and other transparent information about a fund’s holdings are important for investors to follow. The schedule of rebalancing for a fund can also indicate its susceptibility to style drift. Some financial data providers may also offer style drift ratio reporting, which allows investors to follow the style drift of a fund.

Investors averse to style drift may want to choose index funds, which are offered with a wide range of strategies including style, theme, value, growth, and momentum. Customized index funds tracking a specific style can be good for investors who seek to mitigate the risks of style drift.