Style Drift and its Considerations and Consequences
In this context, the word “Style” refers to how an investment manager defines its investment universe. It can be used to describe that the manager focuses on growth or value investments, or that the manager focuses on stocks with a certain capitalization, or size. These are the two primary categorizations of Style, but there are others that exist. Generally, discussions of Style pertain to equity investing, and this blog will focus on equities. But style exists within other asset classes as well.
When analyzing a fund, it is important to be able to make an apples to apples comparison between funds and their peers as well as identifying an appropriate benchmark. Style categorization can help analysts identify the right candidates for these comparisons. For example, if an analyst is evaluating a fund that focuses on Small Cap value stocks, it would be inappropriate to compare it to a benchmark that focuses on Large Caps, like the S&P 500, or to compare it to another manager that is focusing on Mid Cap Growth companies.
Considering Style is an essential part of the initial fund analysis. But, making sure that a manager executes and stays faithful to their Style after allocating to them, is equally important. This is where the term Style Drift enters the conversation.
Style Drift refers to when a manager departs from their stated investment objective over time. By way of example, if a manager defines its fund as a deep value equity fund that focuses on stocks within the S&P 500, but 2 years after allocating to that fund, the allocator notices that the manager has been buying high growth small cap stocks within the portfolio. This is an example of manager Style Drift.
Style Drift can occur due to a manager’s decision making, but it can also occur due to capital appreciation or through general equity market development. Consider a small cap stock, if that stock continues to grow and appreciate, at some point its capitalization is going to migrate to mid-cap, if this stock was held within a portfolio, you might observe fund Style Drift from small cap towards mid cap.
When Style Drift occurs because of an investment manager’s activity, it is generally a warning sign to reexamine the manager’s approach and investment process. Following the great financial crisis of 2008, growth stocks, led by the largest tech companies, greatly outperformed value stocks. During this time, it was not uncommon to see value managers adding growth stocks to their portfolio to participate in the rally of growth stocks. This resulted in a lot of Style Drift within value funds. While a value manager might have a great investment thesis and be confident in a growth stock, it is important to realize that as a value manager adds more growth names to the portfolio, the allocator can no longer consider their allocation to that value manager, as a pure play value exposure.
It is very important to be aware of and evaluate Style Drift. If managers within a portfolio are exhibiting Style Drift, they could potentially be moving towards the same Style and in that case, there could be a scenario where they don’t provide the expected diversification benefits because their investments have become overlapping. For example, if managers are adding small cap value exposure and there is a correction within small cap value stocks, your portfolio could have an unanticipated drawdown. Due to this, it is important to evaluate a manager’s performance and investment process but also to ensure they are delivering the expected exposure and not exhibiting Style Drift.
There are two main approaches to Style analysis. While neither is all encompassing, the two methods when used together can give a more complete view of an investment manager’s Style. We will explain the two primary methods and discuss some of their pros and cons. These Style analyses are important tools that can help identify Style Drift.
Returns based Style Analysis - this method of Style analysis is a regression approach that compares the portfolio’s total returns to the total returns of various Style-based indices, like the Russell 2000 Growth index. Through this method, the analyst can make inferences about Style based on how closely the portfolio returns resemble those of the different Style based indices. This approach normally uses 4-6 indices, half of which would be growth or value indices distributed across capitalizations (Large-cap, mid-cap, small cap). This approach is most effective when you want to observe Style over longer time periods, as it can use five or even ten year returns to assess a manager’s Style.
Holdings Based Style Analysis - This method assesses Style based on the underlying holdings within a fund. It grades each holding on growth or value and size and takes a weighted average. This gives the resulting Style of the fund overall. This approach is very useful to consider what the Style of a fund is at a moment in time, but it can be deceiving. Let’s say for example that a growth manager had previously held a lot of value stocks, but right before a holdings-based Style analysis was conducted, the manager sold all of the value stocks and replaced them with growth stocks. The Style analysis would likely conclude that the manager was following through on the stated objective and delivering a growth portfolio even though they had meaningful value exposure prior to the sale.
Style Drift is an important consideration when constructing portfolios and conducting due diligence on managers. In order to make sure investors are making an appropriate comparison before allocating and ensure that managers are delivering the intended exposure, one should consider the investment manager’s Style and ensure that they are acting consistently with that Style. These considerations are part of our investment process at Crystal Capital Partners, and as we meet with managers throughout the year, we take time to ensure that they are delivering on their stated investment objectives.