Many of us learned a new skill during the Covid pandemic, and for me it was cooking from scratch. I love the simple pleasure of choosing fresh natural ingredients and then turning them into a nutritious meal. I'm not an expert cook, believe me, but I'll never go back to buying processed food with long lists of obscure ingredients.

There are close similarities between food and investments. Building a portfolio is rather like shopping for groceries. You can either fill your cart with wholefoods like organic meat, wild-caught fish, fresh fruit and vegetables, nuts, grains and legumes. Or you can buy pre-packaged food you can just put in the microwave — yes, far more convenient, but not very good for your long-term health.

Actively managed mutual funds can be rather like convenience foods. They're often heavily advertised and made to look as though they're much better for us than they are. Worse still, you may get a nasty surprise when you discover what they actually contain.

In fact, the labeling of investment products can be even more misleading than food labels. Take equity funds, for example. Stocks come in many varieties. There are large-cap, mid-cap, small-cap and micro-cap stocks, growth stocks, value stocks, momentum stocks, low-volatility stocks, high-dividend-yielding stocks — the list goes on. 

The problem, as Mark Hebner explains in Step 6 of his book Index Funds: The 12-Step Recovery Program for Active Investors, is that no industry-wide standards exist for defining these terms.

"To make matters even more difficult," Hebner writes, "carefully crafted fund prospectuses give active fund managers significant leeway to deviate from their fund's stated investment style. As a result, companies with divergent risk and return characteristics are often lumped together into the same style."

Style drift creates unwanted risks

The phenomenon Hebner is referring to is called style drift. Not only is it widespread, it's also deeply problematical for investors for two main reasons.

The first problem with style drift is that, if it's not properly monitored, it can expose investors to risks they either don't want, don't need, or can't afford, to take. What's more, investors usually even know it. Why is that? Well, certain types of stocks are riskier than others. Smaller stocks, for instance, are more risky than larger stocks, and value stocks are riskier than growth stocks. Yet it's very common for large-cap fund managers to drift into mid and small caps, or for growth fund managers to invest in value stocks. 

In his book Unconventional Success: A Fundamental Approach to Personal Investment, David Swensen, the late Chief Investment Officer at Yale University, described style drift as a significant risk for investors. "Style drift," he wrote, "undermines the integrity of an investment portfolio. Investors must ensure that the managers they select adhere to their stated investment styles, or the portfolio may suffer from unintended and unwanted risk exposures."

This might not seem like a big deal, but it really is. It can be very unsettling, for example, for an investor nearing retirement to discover, perhaps after a market crash, that their chosen fund manager was taking more risk with their investments than they thought.

An extreme example of this is what Mark Hebner calls "style drift on steroids," when a bond fund manager invests in stocks. According to data from Morningstar, no fewer than 468 mutual funds classified as bond funds held stocks at the end of the fourth quarter of 2021. A somewhat extreme example is the Allspring Real Return Fund, which Morningstar reported had just over 16.5 percent of its assets in equities at the time.

Hard to compare performance

The second problem that style drift causes for investors is that it makes it hard to evaluate fund performance. Large-cap funds, for example, should be compared with other large-cap funds, and growth funds with other growth funds. But what if a large-cap manager has drifted into small-caps or a growth manager into value? In both cases, the fund's returns are likely to diverge from the benchmark. In other words, it's not a like-for-like comparison.

It's even harder to compare performance when a bond fund invests in stocks. Over time, stocks are expected to deliver substantially higher returns than bonds. So a bond manager who drifts into equities is likely to outperform a bond fund manager who sticks to bonds — not because he or she is any more skillful, but simply because they've taken more risk.

Of course, fund managers tend not to call it style drift. The term they prefer to use is tactical asset allocation. By tweaking their investment style, and trying to increase their exposure to the right assets at the right time, they aim to beat the broader market. Unfortunately, the evidence shows us that tactical asset allocation usually produces lower net returns in the long run than a simple static allocation.

You can't blame active managers for trying to outperform through tactical allocation — that's what they're paid for after all — but it's another example of how the interests of fund managers and investors are misaligned. As a 2020 study called The Shrouded Business of Style Drift in Active Mutual Funds shows, fund managers have a financial incentive to drift between styles because their salaries and bonuses depend on delivering short-term performance.

Lessons for investors 

What, then, does all this mean for investors? First, you should stay on your guard and specifically for evidence of style drift. Morningstar provides two useful tools to help you see how closely a fund has adhered to its stated objective:

• The Morningstar Style Box is a nine-square grid that provides a graphical representation of a fund's investment style. For equity funds, it classifies securities according to market capitalization (the vertical axis) and growth and value factors (the horizontal axis).

• The Morningstar Global Risk Model goes further than the Style Box by estimating exposures to an additional five factors that also help discern whether a strategy delivers what it promises.

 

Better still, however, is to disregard actively managed funds altogether. As well as being cheaper and producing better cost- and risk-adjusted returns in the long run, index funds have the advantage of style purity. If you buy a US small-cap index fund, for example, the fund will contain nothing but US small-cap stocks. A government bond fund will only contain government bonds.

Just like wholefoods, you know exactly what you're getting with index funds — simple, style-pure, transparent investments, without any nasty surprises.

 

*Quotes and pictures are utilized for illustrative purposes only and should not be construed as an endorsement, recommendation, or guarantee of any particular financial product, service, or advisor.

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ROBIN POWELL is IFA's Creative Director. He always works as a freelance journalist and author, and as Editor of The Evidence-Based Investor.

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This is not to be construed as an offer, solicitation, recommendation, or endorsement of any particular security, product or service. There is no guarantee investment strategies will be successful. Investing involves risks, including possible loss of principal.  Quotes and pictures are utilized for illustrative purposes only and should not be construed as an endorsement, recommendation, or guarangee of any particular financial product, service, or advisor. For more information about Index Fund Advisors, Inc, please review our brochure at https://www.adviserinfo.sec.gov/ or visit www.ifa.com.