Style Drift

“How many legs would a sheep have if you called its tail a leg? Four: Because calling its tail a leg doesn’t make it one.

__Abraham Lincoln as quoted by Larry E. Swedroe in Rational Investing in Irrational Times, pg. 123

Larry E. Swedroe in his great work on Index Fund investing Rational Investing in Irrational Times (pages 126-127) reviews a study which looked at the phenomenon of mutual fund “style drift”, the tendency of a fund to shift or drift away from that which it claims to be. Mr. Swedroe writes as follows:

“A study entitled “Mutual Fund Objective Misclassification” sought to determine whether mutual funds actually adhered to their stated objective or whether, in pursuit of the Holy Grail of outperformance, they style-drifted.(4) The authors used Morningstar’s database for the period 1993-96. Morningstar classifies funds by their stated objective. It reviews a fund’s prospectus and how the fund is marketed. Morningstar does not then try to “outguess” the fund sponsor. If the fund sponsor calls its fund a growth fund, Morningstar classified it as such. However, this can be misleading if a fund either style-drifts or tries to “game” its benchmark. For example, a fund might state its objective as low risk and actually pursue a high-risk strategy. Or, it might state its objective as smallcap but purchase large caps if the manager believes that large caps are “hot” and by doing so he can beat his benchmark. To test for style drift, the authors evaluated funds based on many well-established investment criteria, such as P/E and BtM ratios, market capitalization, dividend yield, and so on. They then compared the fund’s actual style to its Morningstar classification. Here is what they found:

Only forty-six percent (484 out of 1,043) had investment attributes that were consistent with the fund’s stated objectives; fifty-four percent of funds were misclassified.

Over one third (353 out of 1,043) of all funds were severely misrepresented. Keep in mind that the Investment Company Act of 1040 states that an investment company will not deviate from its investment policy unless authorized by a majority of shareholders.

Over the very short period covered by the study, fifty-seven percent of the funds that survived changed their investment style at some point.

Only twenty-seven percent of funds held constant their investment attributes throughout the period.

Twenty-three percent of funds were found to be less risky than their stated objectives.

Thirty-one percent of funds were found to be more risky than their stated objectives.”

4. Moon Kim, Ravi Shukla, and Michael Thomas, “Mutual Fund Objective Misclassification,” Journal of Economics and Business, July/August 2000.

Summary

At proper asset allocation elsewhere on this web site, we discuss three core principles of Modern Portfolio Theory, and how adherence to these principles can “optimize” a portfolio. We discuss the vital role in “class” in effecting a proper asset allocation plan. We discuss the exquisite utility of Index Funds as the investment instruments of choice in fashioning a proper asset allocation plan because of the purity in reflecting distinct asset classes and not “drifting” from the asset class it seeks to reflect. On this web page, we reviewed studies of “style drift” in the average mutual fund, a significant defect in any asset allocation plan which relies on reliability.