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Beware of Style Drift in Mutual Funds

Style drift refers to a situation in which a mutual fund begins to follow an investment strategy other than the one it originally followed. It can occur in any number of ways: The manager could begin to invest more heavily in international stocks, in stocks of distressed companies, in growth stocks, etc.

The danger of style drift isn’t necessarily that the manager is making a poor decision (although that can certainly happen), but rather that your asset allocation will end up being something other than what you’d intended. This leads to two primary problems:

  1. Inappropriate levels of risk and
  2. Insufficient diversification

Inappropriate Levels of Risk

This is pretty self-explanatory: If a fund that you own suddenly begins to invest more heavily in riskier securities, your portfolio’s level of risk will increase as well–often without you even knowing it.

Of course, the same thing can happen in the other direction. A fund manager could shift the fund’s portfolio significantly toward less risky assets, thereby leaving you with less risk (and expected return) than you’d intended.

Insufficient Diversification/Accidental Overlap

Style drift in your portfolio can result in insufficient diversification as a result of having funds that overlap. For example, if you buy two international stock funds:

  • An emerging markets fund, and
  • An developed markets fund

…and either of the funds begins to shift toward the strategy of the other, you would no longer be as diversified as you had intended due to the new overlap between the funds.

Avoiding Style Drift

One of the best things you can do to avoid style drift in your portfolio is to read the prospectus for each of your funds. See how much leeway the fund manager is allowed in terms of how he can invest the fund’s assets, and take that into account when you determine your asset allocation.

Alternatively, you can just avoid actively managed funds altogether. Index investors have little to worry about when it comes to style drift. As long as a fund continues to follow the index it originally followed (or one that performs a similar role), an index investor will know what’s in his portfolio.

Final note: Target retirement funds can be subject to style drift, even if they’re made up entirely of index funds. Should the fund management company decide to change the fund’s glide path, an investor could end up with an asset allocation significantly different from the one he intended.

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Comments

  1. Rick Francis says:

    Mike,

    While I certainly wouldn’t want my investments changing without my knowledge- I wonder how much of a difference diversifying between different stock categories really makes? Have you seen any data that even gives a rough estimate?

    I expect most of the world’s economic growth to happen outside the USA but the S&P500 are really global companies. Do we really get that much more diversification with an international fund? If we do, is it worth the extra cost of an international fund?

    -Rick Francis

  2. Rob Bennett says:

    Alternatively, you can just avoid actively managed funds altogether.

    Amen.

    I am not dogmatic about avoiding non-index funds. But style drift is a serious problem. The benefit of long-term investing is that you are giving your strategies time to work out. If the fund manager is changing his strategy, he is also changing your strategy (possibly without you even knowing about it). So the benefit of long-term investing is lost to you.

    Unless you are willing to take the time to follow your fund closely enough to be sure that there is no style drift going on, I think you are better off in index funds. I view the transparency of index funds as a big argument in their favor. I don’t want people playing games with my funds and index funds are simple enough that gamesmanship is not possible.

    Rob

  3. Hi Rick.

    You raise a good question. For some data on the topic, you could take a look at the returns earned by Vanguard’s Total International Stock Fund and compare them to an S&P 500 fund.

    The answer, to save you the time, is that you’re right. The correlation is pretty darned high.

    The difference in expense ratios is 0.16%. Personally, I’m willing to pay that price for the (admittedly potential) benefits of further diversification.

    However there are certainly many well-informed investors–John Bogle comes to mind–who’ve opted to keep international exposure to a minimum for precisely the reasons you mentioned (as well as a concern about the additional level of risk from fluctuations in exchange rates).

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