About style drift

Style drift can occur in many ways. For example, a small-cap fund may drift into the mid-cap space if a portfolio manager continues investing in winning companies that grow out of the small-cap space as a result of their success.

Drift can also be intentional when certain investment types fall out of favor and the portfolio manager chases other investments to try to capture better returns. Sometimes this involves moving the portfolio into a higher level of cash, or in the fixed income world, exposing the fund to more risk by investing the fund more into lower quality credit to try to capture better returns.

The industry has many “go anywhere” mutual funds that aren’t bound by a specific investing style. The portfolio managers of these funds are free to invest in areas they feel are attractive at the moment, which means their risk characteristics may float from large-cap growth to large-cap blend to potentially large-cap value, for example.

It is important to not assume that just because a fund is categorized today as a large-cap value fund that it will always provide that type of investment exposure in the future. When considering funds for a portfolio, don’t just rely solely on fund names or stated investment styles. Also make a note to check the prospectus if the funds drift over time, altering your portfolio diversification.

Style drift leads to asset allocation shifts

No matter the cause of a mutual fund’s style drift, the fact is that it may expose your portfolio to unwanted and potentially significant consequences if the overall asset allocation you established changes. With style drift, asset allocation is now out of your control. As a result, your portfolio could have inadequate diversification or unintended overlap among its holdings, leaving you potentially under or overexposed to certain asset classes.

For example, you may have allocated 20% of the portfolio to large-cap growth and another 20% to large-cap value. In our example, the large-cap growth portfolio manager believes the economy is slowing down, diminishing the prospects for growth stocks, and begins shifting the allocation to more value-oriented stocks.

As a result, your portfolio may suddenly have 25% invested in large-cap value and only 15% in large-cap growth stocks, which no longer meets your long-term allocation objectives.

Another example where style drift may affect your portfolio is reflected in your risk tolerance. It’s harder to keep your portfolio risk levels within specific parameters if the investments in the mutual funds shift outside of the specified investment strategy. If your funds begin investing more heavily in riskier securities, the overall risk level in your portfolio increases. And if your funds shift toward less risky securities, you may see a result in lower overall rate of return from what you expected.

While funds that drift may perform well in a vacuum, they may not be fulfilling the purpose you had for them as one component of your diversified portfolio, either in terms of their holdings or risk levels.

It may be difficult to stay on top of a mutual fund’s true exposures because most fund families publicly report their holdings with a 30- to 90-day lag. But once you become aware of a fund that appears to drive regularly in and out of its investment strategy, it’s probably time to look for a different fund to fulfill that specific niche within your portfolio’s asset allocation.