Style Drift
Style drift occurs when a mutual fund’s actual and declared investment style differs.[1] A mutual fund’s declared investment style can be found in the fund prospectus, which investors commonly rely upon to aid their investment decisions. For most investors, they assume that mutual fund managers will invest according to the advertised guidelines; however, this is not the case for a fund with style drift. Style drift is commonplace in today’s mutual fund industry, making no distinction between developed and developing markets according to studies in the United States by Brown and Goetzmann (1997) and in China as reported in Sina Finance.[2][3]
When style drift presents itself in a mutual fund, the investment information about the fund becomes misleading. [4] Given that, in reality, style drift is generally undetected, the information asymmetry of investment information has important consequences for fund investors seeking to maximize fund returns. Researchers such as Brown, Harlow and Zhang (2012) demonstrate that a deviated fund tends to become another fund product of a different risk-return profile that is not aligned with an investor’s initial investment goal.[5] This is supported by a recent study by Chua and Tam (2020), who found that style drift behavior prevents fund managers from picking superior stocks to meet investors' expectations for fund performance.[6] In the same study, Chua and Tam (2020) find that fund managers have a tendency to use style drift to maximize compensation, which is a demonstration of agency problems in the mutual fund industry.
Active portfolio and style investing
It is widely acknowledged that style drift is a common practice, particularly by active mutual funds, in the financial markets.[7] While passive funds employ a buy-and-hold strategy, often following an index, active funds take on an active investment approach by picking stocks that move in and out of the market.[8] It is therefore common for active funds to embrace different investment styles, and consequently, investors of active mutual funds need to keep an eye on their fund's risk exposure since style drift can impact it.[9]
The rise of funds’ investment styles can be traced back to studies on market anomalies.[10][11] Researchers on market anomalies view that stock returns are driven by factors related to “size”[12] and “valuation”[13] effects, other than a single factor exposure of market risk under the assumptions of the Capital Market Pricing Model (“CAPM”) developed by Sharpe-Lintner-Mossin in the 1960s.[14] The findings that stocks have distinctive characteristics eventually gave rise to the rise of investment style. This stock style has prompted the creation of numerous style indexes to track various stock market segments, for example, Standard &Poor’s (S&P) style indices 500 to represent the large-cap market, the mid-cap market is represented by S&P mid-cap 400, the small-cap market is represented by S&P small-cap 600, and growth and value indices.[15]
Depending on a fund's investment objective, the fund manager must adopt various investment strategies in its portfolio construction to add value to fund returns. Strategies can be categorized into:[16]
- technical analysis – contrarian or momentum approach; and/or
- anomalies/stock attributes—calendar effect, stock characteristics with respect to size, value or growth.
It is an industry-wide practice that mutual funds are categorized into investment styles that reflect the investment objectives and the underlying strategy of funds.[17] The practice is brought about by a market anomaly in a financial market demonstrating that different investment styles have dissimilar risk and return characteristics that serve important implications on fund performance attribution and outcome.
Style drift definition and metrics
Style drift is often referred to as “portfolio/style tilt”,[18] “style volatility”,[19] and “style shifting”[20] by researchers and practitioners to broadly account for the divergence of a fund’s actual investment style from its declared contractual investment strategy in the fund prospectus. To determine the investment style of an active fund, and subsequently to detect style drift, two methods are commonly used. They are:
- Returns-based analysis
- Holdings-based analysis
Returns-based analysis
Returns-based approach is a simpler approach to determining the investment style of an active fund. It is done by regressing fund returns against the returns of a set of passive style indexes or some constructed portfolios. While the returns-based method is a low-cost approach, it has a few disadvantages in respect of its measurement. Specifically, it is advantageous to use a returns-based style technique if the investment style of a mutual fund is stable over time [21]; the technique also assumes factor exposures are constant.
Holdings-based analysis
In contrast to the returns-based technique, the holdings-based approach better reflects the true investment style of an active fund, but analysis requires more time and is more costly to execute. Essentially, the holdings-based technique examines the actual stock characteristics in the portfolio holdings.[22] Fund portfolio holdings offer knowledge on the characteristics of the stocks which need to be assessed individually. Examples of these stock style attributes are size, value and growth dimensions.
Style drift on fund returns
The outcome of how an active mutual fund is managed is of great importance to fund investors. One of the key conclusions in the existing literature is that some funds perform worse than others due to larger portfolio risk exposure and higher trading costs, which are found to be correlated with greater volatility in investment style.[23] In another study by Chua and Tam (2020)[6], fund managers engaging in style drift are found to have weaker stock picking abilities. This risk taking through style drift can thus cause a possible loss of confidence in the fund market.
References
- ↑ Style Drifts. (n.d.) Farlex Financial Dictionary. (2009). Retrieved July 8 2021 from https://financial-dictionary.thefreedictionary.com/Style+Drifts
- ↑ Brown, S.J., Goetzmann, W.N., 1997. Mutual fund styles. Journal of Financial Economics 43, 373-399.
- ↑ Sina Stock Finance News (November 22, 2020) https://stock.finance.sina.com.cn/stock/go.php/vReport_Show/kind/11/rptid/659324590642/index.phtml
- ↑ Kim, M., Shukla, R., Thomas, M., 2000. Mutual fund objective misclassification. Journal of Economics and Business 52, 309-323.
- ↑ Brown, K.C., Harlow, W.V., Zhang, H., 2012. Investment style volatility and mutual fund performance. Working paper. University of Texas, Austin. http://faculty.mccombs.utexas.edu/keith.brown/Research/stylevolatility-wp.pdf
- ↑ 6.0 6.1 Chua, A.K.P., Tam, O.K., 2020. The shrouded business of style drift in active mutual funds. Journal of Corporate Finance 64, 101667. https://papers.ssrn.com/sol3/papers.cfm?abstract_id=3626137
- ↑ Indro, D.C., Jiang, C.X., and Lee, W.Y., 1998. Mutual fund performance: a question of style. The Journal of Investing 7, 46-53
- ↑ The Active vs. Passive Framework, Updated. Morningstar (2016). Retrieved July 8 2021 from https://www.morningstar.com/articles/758689/the-active-vs-passive-framework-updated
- ↑ Ellis, C.D., 2017. The end of active investing? Financial Times (January 20, 2017). https://www.ft.com/content/6b2d5490-d9bb-11e6-944b-e7eb37a6aa8e
- ↑ Banz, R.W., 1980. The relationships between return and market value of common stocks. Journal of Financial Economics 9, 3-18
- ↑ Basu, S., 1977. Investment performance of common stocks in relation to their priceearnings ratios: a test of the efficient market hypothesis. Journal of Finance 32, 663-682
- ↑ Banz, R.W., 1980. The relationships between return and market value of common stocks. Journal of Financial Economics, 9, 3-1.
- ↑ Basu, S., 1977. Investment performance of common stocks in relation to their price-earnings ratios: A test of the efficient market hypothesis. The Journal of Finance, 32(3), 663-682.
- ↑ Sharpe, W.F., 1964. Capital asset prices: A theory of market equilibrium under conditions of risk, The Journal of Finance, 19 (3), 425-442.
- ↑ ETFs With Style. Morningstar (2010). Retrieved July 8 2021 from https://www.morningstar.com/articles/355113/etfs-with-style
- ↑ Key Factors for Evaluating Mutual Funds. Morningstar (2020). Retrieved July 8 2021 from https://www.morningstar.com/articles/990067/key-factors-for-evaluating-mutual-funds
- ↑ Morningstar Category Definition. Morningstar. (2019). Retrieved July 8 2021 from https://sg.morningstar.com/sg/news/115635/morningstar-category-definition.aspx
- ↑ To Tilt Or Not To Tilt Your Portfolio Design. Forbes. (2014). Retrieved July 8 2021 from https://www.forbes.com/sites/rickferri/2014/07/17/to-tilt-or-not-to-tilt/?sh=521b9c1d4986
- ↑ Brown, K.C., Harlow, W.V., Zhang, H., 2012. Investment style volatility and mutual fund performance. Working paper. University of Texas, Austin. http://faculty.mccombs.utexas.edu/keith.brown/Research/stylevolatility-wp.pdf
- ↑ Gallo, J.G., and Lockwood, L.J., 1999. Fund Management Changes and Equity Style Shifts. Financial Analysts Journal 55, 44-52
- ↑ Buetow, G.W., Johnson, R.R., and Runkle, D.E., 2000. The Inconsistency of Return– Based Style Analysis. The Journal of Portfolio Management, 26(3), 61-77.
- ↑ Daniel, K., Grinblatt, M., Titman, S., and Wermers, R., 1997. Measuring mutual fund performance with characteristic-based benchmarks. Journal of Finance 52, 1035-1058
- ↑ Brown, K.C., Harlow, W.V., Zhang, H., 2012. Investment style volatility and mutual fund performance. Working paper. University of Texas, Austin. http://faculty.mccombs.utexas.edu/keith.brown/Research/stylevolatility-wp.pdf
Style Drift
Style Drift
This article "Style Drift" is from Wikipedia. The list of its authors can be seen in its historical and/or the page Edithistory:Style Drift. Articles copied from Draft Namespace on Wikipedia could be seen on the Draft Namespace of Wikipedia and not main one.
