Beware of Style Drift in Mutual Funds
- 0 Comments
Style drift refers to a situation in which a mutual fund begins to follow an investment strategy other than the one it originally followed. It can occur in any number of ways: The manager could begin to invest more heavily in international stocks, in stocks of distressed companies, in growth stocks, etc.
The danger of style drift isn’t necessarily that the manager is making a poor decision (although that can certainly happen), but rather that your asset allocation will end up being something other than what you’d intended. This leads to two primary problems:
- Inappropriate levels of risk and
- Insufficient diversification
Inappropriate Levels of Risk
This is pretty self-explanatory: If a fund that you own suddenly begins to invest more heavily in riskier securities, your portfolio’s level of risk will increase as well–often without you even knowing it.
Of course, the same thing can happen in the other direction. A fund manager could shift the fund’s portfolio significantly toward less risky assets, thereby leaving you with less risk (and expected return) than you’d intended.
Insufficient Diversification/Accidental Overlap
Style drift in your portfolio can result in insufficient diversification as a result of having funds that overlap. For example, if you buy two international stock funds:
- An emerging markets fund, and
- An developed markets fund
…and either of the funds begins to shift toward the strategy of the other, you would no longer be as diversified as you had intended due to the new overlap between the funds.
Avoiding Style Drift
One of the best things you can do to avoid style drift in your portfolio is to read the prospectus for each of your funds. See how much leeway the fund manager is allowed in terms of how he can invest the fund’s assets, and take that into account when you determine your asset allocation.
Alternatively, you can just avoid actively managed funds altogether. Index investors have little to worry about when it comes to style drift. As long as a fund continues to follow the index it originally followed (or one that performs a similar role), an index investor will know what’s in his portfolio.
Final note: Target retirement funds can be subject to style drift, even if they’re made up entirely of index funds. Should the fund management company decide to change the fund’s glide path, an investor could end up with an asset allocation significantly different from the one he intended.
Get started saving: EverBank’s money market account is currently offering over 3% for new customers. (Current as of 8/21/09.)
