Aurora Borealis
1 August 2017 CFA Institute Journal Review

Style Drift: Evidence from Small-Cap Mutual Funds (Digest Summary)

  1. Michal Szudejko, CFA
Focusing on small-cap mutual funds, the authors find evidence that larger and older small-cap funds tend to allocate, on average, 27% of their portfolios to mid- and large-cap stocks. By doing so, they expose investors to unanticipated risks, with no offset from higher abnormal returns or performance persistence.

How Is This Research Useful to Practitioners?

The authors touch on a critical subject for the investment industry. Investors who wish to achieve a specific exposure in their portfolios acquire mutual funds on the basis of the funds’ stated objectives. The key issue here is that although such funds may declare these objectives in their prospectuses, no assurance is made that they will stick to these objectives. The managers of these funds may decide to “drift away” from the official investment strategy, possibly exposing investors to unanticipated and unwanted risks.

It should be noted that SEC regulations require mutual funds to hold at least 80% of assets that match the investment objective suggested by the fund’s name.

The authors find that holdings in mid-cap and large-cap stocks are widespread among small-cap funds, causing significant differences in the risk exposures. On average, small-cap funds in the sample allocate 27% of their net asset value to mid- and large-cap stocks. Their allocation is in excess of the 20% allowed by the SEC rule in every year since 2000. The authors find that the top decile of funds holds over 60% of their portfolios in sources other than small-cap companies. A drift of such scale could mislead investors. The usual reason for the drift is the search for higher return. Even after the authors control for risk factors, however, this particular drift offers no compensation for increased risk exposure, in the form of either an above-average performance or performance persistence.

The authors believe that prior researchers’ findings on style drift are of limited value, because they offer no clear conclusions regarding the consequences of style drift and are not specific to the type of style (e.g., growth or value).

Investors, regulatory bodies, and fund managers alike may not be fully aware of the consequences of style drift for investment portfolios.

How Did the Authors Conduct This Research?

The authors contribute to the literature on investment style drift. The key innovation offered is its focus on specific types of funds and specific types of drift.

Using the factor model, which relies on index-based factors that are more suitable for the performance evaluation of mutual funds, the authors perform univariate tests and panel data regressions.

They select funds from the CRSP Survivor-Bias-Free US Mutual Fund Database. The data cover 1995–2010 and include monthly returns, total net assets, historical fund names, investment style, and fee structure.

Small-cap funds are identified by both CRSP Style Code variable and fund name. The small-cap companies are selected from the Russell 2000 Index and the large-cap companies from the Russell 1000 Index. The final sample consists of 615 small-cap funds over January 1995–March 2010, ranging from 61 funds in March 1995 to 386 in December 2005. Information on the holdings of small-cap mutual funds is obtained from Thomson Reuters.

Abstractor’s Viewpoint

The authors highlight that several small-cap funds maintain investments that are in conflict with their official objectives and that such behavior is contrary to official SEC rulings.

Style drift seems to be a widespread phenomenon in the investment industry. There are famous cases of style drift, including Fidelity’s Magellan Fund in the 1980s and Vanguard’s Explorer Fund in the early 1990s. A Wall Street Journal article (2 May 2013) revealed that managers not only stray from stated objectives by acquiring “inappropriate” classes of a given asset but also may include different types of assets in the fund (e.g., a bond fund may acquire stocks). Such behavior may lead investors to believe, mistakenly, that managers can achieve higher-than-average performance compared with similar funds.

The authors identify a serious problem. The question is whether it requires a general regulatory action. I would suggest addressing individual cases of funds that deviate substantially from their declared investment style while failing to provide sufficient disclosure. In fact, a fund’s investment strategy, stated in its offering prospectus, is typically quite general and differs from the marketing materials and verbal statements offered to interested investors. The discrepancy between what a fund intends to do (as specified in its investment strategy) and what it actually says to potential investors may constitute an intention to engage in wrongdoing. The fundamental question is whether investors seeking specific exposures should include actively managed funds in their portfolios. Finally, some investors may accept style drift if they know about it and understand it—and are happy with the extra return achieved.

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