By Peter Mastrantuono
It doesn’t take much to upset the careful calibration of a sound asset allocation. As smart investors know, asset allocation is the primary determinant of a portfolio’s return. Equally important, however, is that an asset allocation represents the appropriate balance of return and risk specific to an individual’s goals and risk profile.
Think of asset allocation as a strategy statement that outlines the preferred level of exposure to a range of asset classes (e.g., cash, bonds, large cap stocks, small and mid cap stocks, international, etc.) and investment styles (e.g. growth and value).
The investments chosen for each portfolio allocation slice (e.g., 25% large cap growth) represent the execution on that strategy. These investments are selected not only on the basis of historical performance, but also on the expectation that they will stick to their defined asset class and investment style.
This doesn’t always happen. When a mutual fund or money manager strays outside the parameters of its mandate (e.g., large cap value), it’s called “style drift”.
Style drift occurs in two ways: 1) unintentional, whereby, for example, a portfolio manager holds onto winners too long and a small cap company becomes a mid cap stock (or larger), and 2) intentional (e.g., a value manager, looking to improve returns, invests in growth stocks because growth stocks are currently in favor).
The Prevalence of Style Drift
One study out of the University of Maryland showed that many fund managers pay scant attention to style drift within the portfolios they manage, though some fund types are more prone to style drift than others.
For instance, small funds drift much more than larger funds (though there is still an unexpectedly high level of drift in larger funds), while funds with a capital growth objective drift more markedly than income-oriented stock funds.
The Problem with Style Drift
Style drift may reduce diversification and introduce a higher degree of potential risk. After all, if half of a large cap value fund’s investments are in growth stocks, the exposure to large cap growth stocks will well exceed the target levels in a desired asset allocation.
The higher risk that style drift introduces might be worthwhile if it came with higher returns. However, the value of style drift is open to debate. The earlier referenced research from the University of Maryland found that portfolio managers increased fund returns through actively trading outside of their style box, though a more recent analysis found no evidence that returns were increased through active style drift management.
Recognizing Style Drift
There are several ways to determine style drift in a mutual fund or other professionally managed portfolio. Telltale signs include significant changes in portfolio characteristics such as industry sector weights and median capitalization and performance dispersion from the appropriate benchmark.
A more in-depth approach is to use returns-based or holdings-based analysis tools to chart style drift over time. These sophisticated tools are generally employed by financial advisors and other investment professionals when they look to measure style drift.
Managing style drift risk, however, best begins by having a conversation with a financial advisor who can evaluate an individual’s specific fund holdings, gauge the degree to which those funds drift and whether more appropriate alternative choices exist.
Peter Mastrantuono is a contributing writer to MyPerfectFinancialAdvisor, the premier matchmaker between investors and advisors. Peter worked for over 30 years in the wealth management industry, focusing on retirement planning, investing, asset allocation and financial planning.