Investors choose mutual funds based on their investment objectives. In pursuit of those objectives, they can choose from among the broader asset classes (such as stocks and bonds) with additional, more specialized options available within each class. These decisions are important because they determine the amount of exposure an investor has to specific types of risk (for example, the risks of small versus large stocks and value versus growth stocks).
An issue for investors selecting actively managed mutual funds is that, while such funds specify their investment objectives in their prospectuses, there is no guarantee they follow their self-stated strategies. In fact, many active managers believe that their ability to drift across styles provides them with an advantage. However, if managers deviate from their stated style, they can expose investors to unanticipated risks.
The question for investors is: Does the evidence demonstrate that active managers are able to take advantage of the opportunity that style drifting provides, or is the ability to style drift one that is “fraught with opportunity”?
Glenn Tanner, William T. Chittenden and Janet D. Payne contribute to the literature with their study “Style Drift among Value and Growth Funds,” which was published in the October 2020 issue of The Journal of Investing. They began by noting that active managers can add (or subtract) value through either timing style drifting (such as a value manager buying growth stocks) or by individual security selection. Their study examined several of the following research questions:
How often do fund managers hold stocks whose characteristics conflict with the fund’s stated strategy? How does this finding fluctuate over time? Are value fund managers more likely to purchase growth stocks, or vice versa? Is this decision impacted by recent returns on the value and growth indices? When fund managers cross over the value/growth line, do they earn higher returns? Do the value (growth) fund managers earn a higher return on their chosen growth (value) stocks than stocks in their own style category provide? When fund managers cross over the value/growth line, are they effective at selecting stocks? Do the value (growth) fund managers earn a higher return on their chosen growth (value) stocks than a growth (value) index?
Their database included quarterly holdings data collected from Bloomberg from 2013-2017 for 140 mutual funds that self-identify as value or growth, for both small- and large-cap funds in each category. They used the Morningstar Category, which is based on the fund’s “portfolio statistics and compositions over the past three years.” To distinguish between value and growth stocks, they used dividend yield and price-earnings ratio. As you review the results, keep in mind that the sample period is relatively short, and the number of funds analyzed was relatively small (140 chosen randomly). With that said, the findings provide some important insights:
Mutual fund managers frequently hold stocks outside their identified style. The effect is greater among active value funds than active growth funds. Small-cap value fund holdings were composed on average of 54% growth stocks over the entire sample period. This proportion remained about the same over the five-year sample period—the average small-cap value fund actually held more growth stocks than value stocks during the sample period. The fund with the largest amount of crossover holdings over the sample period had over 90% of its holdings in growth stocks (in 2017). Crossover holdings among large-cap value funds comprised 35% of total holdings for the entire sample period; however, there was considerable variation in that percentage over time, with average crossover holdings ranging from 27.4% in 2017 to 38% in 2016. In 2015 and 2016, the maximum holdings of growth stocks in small-cap value funds was 100%. Small cap growth funds’ holdings on average contained only 6% value stocks, and there was no year during which the average crossover holdings exceeded 9%. Over the same period, the maximum crossover holdings for small-cap growth funds was 20.6% (in 2013). For large-cap growth funds, the percentage of crossover holdings was small—the average over the sample period was 9.1%. There is weak evidence that managers of large-cap growth funds can time their investment in value stocks. There is strong evidence that both large- and small-cap growth fund managers can successfully select underpriced value stocks. There is no evidence that active value managers are able to add value either through timing factors or by individual security selection. The higher the expense ratio, the more stocks the fund held against style, consistent with the conjecture that higher expense ratios pressure fund managers to achieve higher returns even if it requires them to invest counter to their stated style.
Their findings are consistent with those of Charles Cao, Peter Iliev and Raisa Velthuis, authors of the 2016 paper “Style Drift: Evidence from Small-Cap Mutual Funds.” Their sample period covered the period 1995-2010. For example, they found that on average small-cap funds allocated 27% of their net asset value to mid- and large-cap stocks (defined as Russell 1000 constituents), peaking at 35%. Their allocation to non-small-cap stocks on average was in excess of 20% in every year following 2000. They also found that small-cap funds investing in mid- and large-cap stocks don’t deliver superior performance (based on a four-factor model consisting of beta, size, value and momentum) relative to the small-cap funds that refrain from investing in large-cap stocks.
Their findings led the authors to conclude that large deviations from fund objectives did not lead to superior out-of-sample performance over their entire sample period and that their study underscores the importance of careful research when choosing a fund. In other words, style drifting doesn’t generate alpha, but it can expose investors to unanticipated/uncontrolled risks.
For investors, it’s important to understand that style drift entails unexpected risks that can undermine their strategic portfolio allocation. The evidence also shows that while investors in funds that style drifted incurred higher fees, those higher fees generally did not translate into superior performance.
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