The Trouble with Style Drift

Style drift occurs when an active fund manager with a stated investment style begins to transform the fund under management into a completely different style. For plan sponsors and investment consultants—anyone with a portfolio of funds—this can wreak havoc when trying to compose a specific mix of assets. Imagine you you bought an apple to put in your fruit salad, but suddenly that apple starts acting more and more like an orange.

In the case of a fruit salad, the impact may be small. However, in the context of a $40 billion portfolio, the consequences could be very real and could cost your clients millions of dollars. Various active funds within a multi-manager fund are chosen to serve distinct functions within the portfolio that go well beyond excess returns. A small-cap emerging market manager may be the main driver of volatility for your portfolio, or your alternative real estate portfolio has been selected to diversify away risk in the core markets. When the underlying manager begins to move away from the stated investment strategy, suddenly the exposures you thought you had no longer work harmoniously.

Manager style drift is important to monitor on both sides of the fence, whether you are an institutional investor or an active portfolio manager. Style drifting can happen subtly. For example, a small-cap growth name that finds its niche and experiences a price boom may drift into the mid/large-cap space over the course of the year. This is just another reason to stay on top of your portfolio’s characteristic profile.

Identifying  Style Drift 

To understand what style drift looks like, let’s focus on growth funds. Growth stocks have a relatively brief period of gains, leading to high turnover and more opportunities to drift into an alternative style. If left unattended, those growth names could start to display characteristics more like a value stock. A lack of turnover can quickly leave you allocated to a less “growthy” set of names driving your returns. To demonstrate the impact of style drift, we look at the fund performance for two hypothetical fund managers: Manager ABC, who sticks to the growth strategy, and Manager XYZ, who allows the growth fund to deviate from its stated objective.

By regressing the returns of an active fund against indices representing various investment styles, we can determine which style our returns most closely mimic. The chart below plots rolling 12-month periods, on a monthly frequency over the last five years. All 60 of those 12-month periods of return were strongly correlated with the returns of the Russell 2000 Growth over the same period.  Therefore, we can conclude that Manager ABC is exhibiting very little style drift, from a returns-analysis perspective.

However, Manager XYZ’s returns don’t line up quite as well.

These style reports are a great place to begin. However, there are several limitations to this type of analysis that require additional examination to get a full picture of how a manager has handled a fund’s assets over time. Namely, we need to be concerned about spurious correlation, the idea that correlation does not equal causation. To take a deeper dive, let’s look at Manager ABC from a holdings-based perspective.

A simple examination of weights over time shows that Manager ABC has remained consistent in terms of exposure to growth (predominately growth, with some blended small-cap securities).

Again, that is not the case for Manager XYZ, where we see notable periods of deviation.

Periods of financial turmoil or financial boom are the most interesting to study, as they are a very trying time for a manager, requiring tough decisions to be made. Is our manager strong enough to withstand the constraints of behavioral finance and continue to follow the portfolio mandate? We focused on a specific crisis period, the August 2015 global equity market sell-off. This sell-off occurred because of several factors coming together at once, including the bursting of the Chinese equity stock bubble triggered by a GDP slowdown, the Greek debt default, and plummeting global commodity prices. The confluence of these events led to a nearly 1900-point drop in the Dow Jones Industrial Average over the course of six trading sessions (August 18-25).

By looking at weights exposures over time, trends in the characteristics of the portfolio, and trading behavior, we can determine if our manager truly did stick by the investment strategy despite pressures to move to something safer. Using a characteristics-over-time chart, we can see that over a five-year span, our manager continuously invested in names with a high expected earnings growth. Manager ABC maintained that aggressive tilt over the benchmark throughout Q4 2015.

Manager ABC also continued to add growth companies to the portfolio despite the negative performance of that style. In the six-month period following the selloff (9/2015 – 3/2016), Russell 2000 Growth was down -7.30% while Value was down -0.44%. As shown below, 43% of the stocks in the portfolio following the sell-off are brand-new names with an average P/E of 75; 26 of those companies have negative earnings. This shows that the manager’s commitment to a growth investment strategy is strong enough to outweigh the financial pressures of underperformance.

We can examine individual companies by charting buys and sells alongside the company’s P/E over time. On average, does the manager tend to let go of companies that have reached their maturity in the “growth” category? The charts below demonstrate that this is indeed the case for Middleby Corporation and Jack in the Box, Inc. The fund manager sold both stocks as their P/E drifted towards the S&P 500 average.

Realizing the Benefits of a Consistent Strategy

Let’s look at the long-term benefits of our manager’s loyalty to the investment strategy during this high-pressure period. Unsurprisingly, because of the weak performance of growth stocks during the sell-off, our manager underperformed the benchmark in Q3 2015:

However, despite the volatility during this period, the commitment to the small-cap growth strategy ultimately allowed the manager to finish ahead of the Russell 2000 over a five-year period, growing the portfolio by a cumulative 172%.

There isn’t always an opportunity to meet face to face with each manager to make a full assessment of who they are and how they’ll behave throughout various conditions. However, by analyzing the trends of the fund and breaking down its holdings, we can formulate our own judgment on whether a manager is susceptible to style drift. Or, when in doubt, there are always index funds!