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Catching the drift

Date: 21 September 2022

Of all the things that bother a fund selector, style drift is high on the list for most investors. Seeing a fund unexpectedly change its emphasis often calls into question the very rationale for holding it. Today in the Fund Buyer we dig a bit deeper into this phenomenon and how to stay on top of it.

If there is one thing fund selectors hate, perhaps with the exception of high fees, it’s style drift. Investing in a fund you think does one thing, only to discover that the fund manager has begun investing in areas you really would not expect, or where it’s not clear they have expertise, is understandably irksome. Style drift causes investors angst for a number of reasons. We all hate surprises and  style drift rarely comes preannounced.  It sneaks up on you. In hindsight it can also be the cause of underperformance, or perhaps the result of underperformance, as a manager tries to defend assets or a track record. It can also cause havoc with a well thought through portfolio of assets that are purposely balanced.

Today I’m going to dig a little deeper, and also shed some light on how we think about and assess style drift. We are finding it a topical issue as shifts in macro leadership highlight where funds have been true to their stated process, and where perhaps they are producing returns that are less in line with expectations.

What are the classic examples of style drift and why does it happen? Real life examples we have seen include shifting from value to growth, or vice versa, significant shifts in the size of companies invested in, such as substantial moves into small caps,, expanding from UK to investing globally, or simply making a significant change in the number of holdings. There are always nuances on an individual fund basis, but these are some of the most frequent offenders.

Why does it happen? From what we see, the most common causes are underperformance, excessive assets and overconfidence.

Why does it happen? From what we see, the most common causes are underperformance, excessive assets and overconfidence. Of those, my experience is that underperformance is the most frequent culprit. A recent example of that can be seen in US equities funds, where managers are more often defined by their style than elsewhere. Until recently it had been a one-way street for growth investors, and that had slowly but surely seen funds that were not investing in the higher growth names really struggle. In many cases this led to them beginning to find ways of buying into higher growth names within their investment process. We saw a lot of this in 2020 from value managers, and as we reported in a previous podcast, some of the very largest growth names became a standard part of many value managers portfolios, notably Microsoft and Alphabet.

There is also academic evidence to back this up. A study by Tanner, Chittenden and Payne, published in the Journal of Investing in October 2020, found evidence of managers frequently holding stocks outside of their identified style. Interestingly, it was the value managers who were least able to profit from doing this, where on average this detracted from performance. Of course, there are as many investment processes as there are investment managers, and the nuances of these may allow names we might think of as growth to be held, but as a broad observation, the study is interesting, and certainly reflects some of what we have seen.

When it comes to a shift in the size bias of a fund, I suspect Neil Woodford will forever stick in most UK investors’ minds - and rightly so, in my view. Whilst he had some experience in that space, the shift to the point where small- and mid-cap were the primary factor bias in his portfolio was a clear change.

Asset size can also have an impact. We all know that asset managers and their sales forces hate turning down flows into a successful fund. Those that do so should always be commended, where that course of action is appropriate to retain the level of outperformance. For some though, the temptation to finds ways to continue to grow will always be there, and that can manifest itself through a steady creep in name count, a move up the market cap spectrum to provide greater liquidity, or in the case of UK and US funds, we have seen some launch global funds. Of course, a new fund launch cannot quite be put in the style drift bucket, but it’s worth considering whether your manager really has the capability to expand outside of the region they have done well in historically and produce the same level of success globally, as well as not get distracted in doing so.

One area up for debate is the shift towards private equity within the investment trust world, and funds investing in a hybrid of public and private equities.

One area up for  debate is the shift towards private equity within the investment trust world, and funds investing in a hybrid of public and private equities. I suspect that is going to take a little longer to conclude, but it certainly represents a shift for some managers, albeit they often reside with asset managers who do have in-house capabilities.

I mentioned one other area - overconfidence. Fund managers are by nature a confident bunch, but we have seen examples where this has been the cause of investing outside of where we would expect. As Warren Buffett once said; “everybody’s got a different circle of competence. The important thing is not how big the circle is. The important thing is staying inside the circle.”

So, plenty of examples of style drift, but how do we spot it? I am afraid, the poor retail investor is at a big disadvantage here. For our team, the way to pick up on this is threefold. Firstly, it’s using quantitative tools. Here you might have access to monthly holdings over the last ten years and can analyse how the portfolio’s characteristics change over time. A basic check might be whether the average valuation of the portfolio goes from below to above the market. This, of course, is only really helpful if you can then have a follow up conversation with the manager to fully understand whether or not his is reasonable. Those manager conversations, whether or not the quantitative data suggests a shift, can also often be the source of the first inkling of style drift.

Both these actions are rarely available to the average retail investor. What is possible is to consider whether or not the returns on any particular month are in line with expectations given the prevailing winds of the market. A weak month might simply be down to stock specific, but an ongoing trend whereby the manager does well or poorly is most likely the best way of alerting.

So, to our conclusions. I think now is an especially relevant time to talk about style drift given shifts in market leadership. Whether you thought you had a fund that was value biased, protected well in down markets, or only really invested in large caps, for some there will be a shock when they find their manager has not quite remained true to that philosophy. This is where the mix of art and science involved in picking funds comes in, and the ability to truly know your manager.

I suspect those investors that have simply chased performance might find more surprises in their portfolio than they would like. At the risk of talking our own book, the only way to really ensure you do not get caught out is to have all the tools at your disposal to really assess them, both the data and the qualitative conversations. It is especially pertinent today, in a period when many are seeking to balance out risks in an uncertain market, and not be too far in either direction when it comes to the prevailing style.

This is a marketing communication and is not independent investment research. Financial Instruments referred to are not subject to a prohibition on dealing ahead of the dissemination of this marketing communication. Any reference to any securities or instruments is not a personal recommendation and it should not be regarded as a solicitation or an offer to buy or sell any securities or instruments mentioned in it.

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