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Style is Good, Style Drift, Not So Much

By: Investor Solutions

By: Investor Solutions

Investors who use actively managed funds as their investment vehicle of choice should take heed as style drift can be a detriment to their wealth. Style drift occurs when a fund “drifts” from its intended investment objective. This can be exemplified by movements in both the large to small and value to growth spectrums. It can be brought on by different factors, for example, when a domestic equity fund invests in fixed income, international equities or even cash. It can also occur when a value fund manager invests in growth companies and/or fails to sell companies whose inherent style has changed. For example, an investor who purchased American Funds Investment Co. of America A (AIVSX)1 thinking they are purchasing a purely large value fund may not realize that the fund has 16.5% of its holdings invested in cash. Another fund, Mutual Shares Z (MUTHX)2 holds 11.6% in cash. Funds with such variations in underlying investments can skew your asset allocation away from its target. Not good if your strategic investment plan calls for something else.

Investors who have done their homework know that approximately 94% of how well your portfolio performs is directly attributable to asset allocation. Market timing and individual stock selection only account for 2% and 4%, respectively. Based on these statistics, choosing the right funds to complement your asset allocation is an integral component of your success or failure as an investor. Unfortunately, because of style drift, there will be times when your investment return falls short of what it could and should have been.

When selecting among the choices available to you, say within your employer sponsored 401k plan, logic would dictate that a fund that has “Small Value” in the name would be a small value fund. You would think! However, there are funds whose name may imply one style but their underlying investments cause them to be categorized otherwise. For example, if you visit www.morningstar.com to evaluate the classification of certain funds, you would find the following:

Mutual Fund Ticker Morningstar Category
T. Rowe Price Small Cap Value PRSVX Small Blend
Blackrock Small Cap Value Inst. PNSEX Small Blend
Dreyfus Small Cap Value DSCVX Small Blend
Oppenheimer Small & Mid Cap Value QVSCX Small Blend
Calvert Mid Cap Value A CMVAX Mid Cap Blend

A graphical depiction of a small blend fund would be:

Apparently what you see isn’t always what you get. Someone who intended to purchase a value fund and ended up in a blend fund will obviously be underrepresented in value and overrepresented in growth. That’s because a blend funds is simply a hybrid of growth and value. If you invest in true growth and value funds, additional investment in a blend fund is unnecessary and may end up introducing more risk for little, if any, additional return.

An investor who may have invested in the above funds as part of a well thought out asset allocation would be severely underrepresented in value funds, which have historically outperformed growth funds. Let’s just see how detrimental style drift can be in a portfolio. The following chart compares annualized returns between small blend and value and large blend and value for the times periods January 1980-December 2006 and January 2000-December 2006. The results show that value has in fact outperformed blend for both market caps in both time periods.

So what is an investor to do?

The answer is quite simple, invest in index funds. Although style drift could occur in an index fund it is far more unlikely. That’s because an index fund exists to replicate an index. From time to time, however, companies may fall out of or into an index either because of market capitalization or style modifications. When this occurs, index fund managers carry out the reconstitution of the funds to include companies that have been added to the index and remove those that are now excluded. Instead of changing their index instantly to reflect this change, many wait a number of days, 30 days, for example, before completing this reconstitution. This enables the manager to sell or purchase these holdings when the price has increased or decreased post-reconstitution, respectively. During this short time period, however, there is a slight degree of style drift. Because index funds were created to track an index, the drift is only temporary.

As with all big decisions, it is important to do your homework. What you see isn’t always what you get. It is up to you, the investor, to peel the layers and get to the truth. If you find the process too daunting or more than you are willing to fuss with, talk to a fee-only independent advisor who will give you unbiased information that will help you invest in funds that will adequately capture the asset allocation you are striving for.

1 www.morningstar.com , February 20, 2007

2 www.morningstar.com , February 20, 2007