- Funds have stated objectives within their investment strategy.
- Style drift occurs when the fund manager strays from those objectives without an investor’s knowledge.
- Style drift can be avoided by owning passively managed mutual funds and ETFs.
Style can be defined as a way to say who you are and what you believe in without speaking. Investors are no different. But unlike fashion, an investor may have a preferred investing style and manage their portfolio accordingly. Over time, that style may shift without their knowledge. In investing, that’s known as style drift.
What is style drift?
Style refers to the investment philosophy and stated objective of a particular mutual fund or exchange-traded fund. Some common investing styles include value, growth, and income. Style drift occurs when a fund manager deviates from the fund’s stated objective.
There are few causes of style drift. Fund managers “may be tempted to invest in a different sector they believe has more immediate growth potential,” says Rachael Camp, a CFP® professional at Camp Wealth Management.
“For example, a large growth fund manager buys value stocks because they think value may have a better year or quarter,” Camp says. “This tends to happen when managers notice another style performing well and want to jump on the trend.”
Style drift can also occur if there are significant movements in the market that affect how the fund is weighted. For example, if a fund’s objective is to own an equal amount of growth stocks and value stocks but growth falls by 50% that year, then the style has drifted. The portfolio would be 75% value stocks and just 25% growth stocks.
To correct this, it’s up to the fund manager to adjust the fund’s holdings to bring it back to its stated objective by buying or selling stocks until the fund is more in line with its goals.
Why can style drift be a problem?
Style drift can be a problem because when investors decide on how to allocate their portfolios, they’re choosing funds that fit their desired investing style. If a fund has drifted, it could leave an investor unknowingly overexposed, potentially taking on more risk than intended.
“An investor may be purchasing a specific style of fund as a buying opportunity,” says Camp. “If an investor notices that small-cap stocks have been beaten down, they may view small-cap stocks as ‘cheap’ and want to buy in at a low point. If this fund manager is deviating away from their style of small-cap stocks and instead purchasing mid-cap stocks, it would disrupt the investor’s plan.”
Asset allocation — the process of deciding how your money will be invested — plays an important role in how your portfolio performs. If a fund you own has drifted, it could have an impact on your short-term and long-term returns.
Certain market cycles can be more beneficial to a particular style. But if drift occurs, an investor may not be rewarded. For example, when interest rates are rising and the economy is expected to slow down, value stocks tend to perform well historically. If you choose a fund with a value style and it drifts away from that style, you may not see the results you were expecting.
How to avoid style drift
Avoiding style drift altogether may require you to avoid actively managed funds. An investment that is actively managed is one where a team of people decide what assets the fund should buy and sell. The intended advantage of actively managed funds is to be more agile during times of uncertainty in the market. This team of managers attempts to move away from low-performing areas and into ones that will perform better.
But, it’s important to note that actively managed funds often underperform the indexes they are designed to beat, data shows. This is in contrast to passively managed funds, which generally don’t make frequent adjustments and exist only to mimic an index rather than attempt to outperform it.
“Style drift is just another reason why I am a big fan of index funds,” Camp says. “You won’t have to guess or try to research the fund’s holdings.”
The bottom line
Style drift is considered a hidden risk because it can take an investor away from their intended goal without their knowledge. The easiest way to avoid style drift is to consider investing in passively managed funds.
Doing so means that you will know what the fund manager is investing in and that those managers are staying within the guidelines. Most importantly, you’ll know that you’re not taking additional risks in an attempt to outperform the market, and that the fund will match the style you selected.