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By: Wilmington Trust
When many people hear the term "drifters," they think of the 1950's doo-wop group whose hit songs included "This Magic Moment," "Save the Last Dance for Me," and "Some Kind of Wonderful." But, when investors hear the term "drifters", they often think of money managers that stray too far from their particular investment style.
Style drift occurs when a money manager deviates from a stated investment mandate by shifting toward another asset class or style of investing. Typically, this occurs when the manager's style or category is out of favor. For example, when small cap stocks are outperforming large cap stocks, large cap money managers may succumb to the temptation to begin purchasing stocks that are smaller than allowed by their investment mandate. Similarly, if the performance of growth stocks exceeds that of value stocks for a prolonged period or by a substantial margin, value managers may begin to buy stocks whose valuations are too lofty to fit their investment criteria. During the late 1990s, many value managers drifted toward more growth-oriented securities, as value investing fell out of favor. Subsequently, many growth-oriented managers began to focus more heavily on valuation as growth stocks fell dramatically from 2000-2006. The year 2007 was the first in many years that saw growth stocks outpace value-oriented securities, leaving investors to ponder market cycles and consider what may come next.
Style drift can also occur within a particular style if managers drift toward certain sector concentrations. Another common pattern in the late 1990s was for managers with a "core growth" mandate to essentially become technology sector managers. Some style drift is predictable: small cap money managers commonly drift into the mid cap space over time. As their asset base grows, the managers can no longer effectively operate in the small capitalization market segment and are forced to drift toward larger securities.
Style drift can create a problem for investors who have selected managers to fill a specific role in a portfolio. If a value manager begins drifting toward growth, then the overall portfolio becomes more growth-oriented than the investor may prefer. Assuming that the investor does not recognize this change, the risk characteristics of the portfolio also change. Even worse, if an equity manager begins holding cash or bonds, then return expectations and time horizons of the portfolio change along with the risk profile (i.e., an equity portfolio can take on the characteristics of a balanced portfolio).
For public securities investments, one way to avoid or minimize style drift is to use index funds for a portion of a portfolio. Even a small allocation to index funds can help to control benchmark risk, which can be useful even when the active managers in a portfolio do not engage in style drift. For example, a core large cap stock portfolio might consist of a value manager, a growth manager, and an index component. The active managers pursue excess returns in their respective style category (value added over the benchmark), while the index portion lowers overall expenses and reduces the benchmark risk (i.e., the risk that the fund deviates too much from the stated benchmark).
The world of alternative investments is more complicated. Today, more and more hedge fund managers are given authority to practice style drift, transforming their focused shops into "multi-strategy" organizations. The motivation for the change is the same as with long-only managers: sometimes a particular investment niche falls out of favor due to changing economic or market conditions.
Consider merger arbitrage - an investment process that essentially shorts the shares of acquiring firms and purchases the shares of target firms in order to capture the remaining spread before a deal closes. As one might expect, the returns from merger arbitrage investments are heavily influenced by the amount of merger activity - whenever there is a dearth of merger activity, the potential returns from merger arbitrage are diminished. Thus, managers in this area have begun to diversify their businesses into other areas which require a similar set of skills. This type of style drift may or may not be good for investors; if the manager's skill set does not translate well into the new investment strategy, then investors should be wary of such style drift. However, the added flexibility may improve portfolio performance through various investment cycles.
In the private equity world, buyout firms became tempted to dip their toes into the venture area in the late 1990s, because of exorbitant venture returns during the dot-com bubble. Similarly, when venture returns are in the tank, some venture capital firms look to "diversify" into other areas.
While there is overlap between certain styles of investing, and manager skill sets are somewhat portable, investors should generally be cautious of asset managers that want to stray from their traditional mandate or area of expertise.
Updated: January 1, 2013
This article is for informational purposes only and is not intended as an offer or solicitation for the sale of any financial product or service or as a determination that any investment strategy is suitable for a specific investor. Investors should seek financial advice regarding the suitability of any investment strategy based on their objectives, financial situations, and particular needs. This article is not designed or intended to provide financial, tax, legal, accounting, or other professional advice since such advice always requires consideration of individual circumstances. If professional advice is needed, the services of a professional advisor should be sought.
© 2013 Wilmington Trust Corporation.