Style drift: Are your mutual funds true to their name?

Most advisors and investors probably know that a mutual fund’s “style” has nothing to do with being fashionable. But what they may not know is how important it is for the funds they pick to stick to their style over the long term to help them reach their goals.

Mutual funds that stay true to their investment strategies help form the foundation of asset allocation success. But not all funds stay true to their name, which can play havoc with the asset allocation strategy of an investor’s portfolio.

In building a portfolio, each mutual fund you select represents a piece in the asset allocation puzzle that together should provide the best opportunity to meet your long-term investment objectives.

Collectively, these pieces determine how the portfolio may perform from both a return and a risk perspective over time. However, these funds could derail your asset allocation if the portfolio managers succumb to “style drift,” which happens when a fund’s underlying investments stray from their defined universe.

Style drift can occur in many ways. For example, a small-cap fund may “drift” into the mid-cap space when a manager hangs onto the winners in the portfolio for too long.

The style drift could also be more intentional, such as when a certain investment type is out of favor and the fund manager chases other investments to try to capture better returns or moves into a much higher level of cash in the portfolio. Or it could be a fixed-income manager who exposes the fund to more risk by moving further out on the duration spectrum or into lower quality credit to try to capture better returns.  

The industry also has many “go anywhere” mutual funds that aren’t bound by a particular style but will fall into a certain Morningstar or Lipper category at any given time based on their underlying holdings.

However, you can’t assume that just because a fund is categorized today as a large-cap value fund that it will provide that type of exposure going forward. Therefore, when you are considering funds for a portfolio, you can’t necessarily rely solely on fund names, current holdings or stated investment styles.

Style drift leads to asset allocation shifts

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

For example, you may have allocated 20% of the portfolio to large-cap growth and 20% to large-cap value. However, let’s say the large-cap growth 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, the portfolio may suddenly have more like 25% in large-cap value and 15% in large-cap growth stocks – which is no longer in line with your long-term asset allocation objectives.

Likewise, it’s difficult to keep a portfolio’s risk levels within specific parameters if the investments in the underlying mutual funds are all over the map. If the mutual funds are investing more heavily in riskier securities, the overall portfolio’s level of risk increases, while a shift toward less risky securities may result in a lower overall rate of return than expected.

What style drift looks like

The following charts show examples of several funds whose holdings have strayed away from their stated investment parameters or their current category.