‘Do fund managers remain true to their stated mandates on their prospectuses?’
Style classification is very important for every fund in attracting fund flows and is highly dependent on the extent to which fund managers comply with self-reported fund indicators (Ainsworth et al., 2008 ). As the fund’s active stock holdings are huge determinants of its actual style inclination, the variation between actual and self- stated investment style is of great significance. This ensures that the rewards of any given fund accrue to its investors. A fund style gives an account of the stock holding attributes of the fund and has, thus, turned into an important feature for investors in choosing a fund. Therefore, style drift can also be described as a situation where a mutual fund deviates from its stated investment style on its prospectus, or from its objective, and shifts towards another investment style (Kurniawan et al., 2011).
Literature such as Wang et al. (2010) and Jansson et al. (2011), has on record noted that the movement between styles is based on the belief that diversification across styles presents a critical control of manager-specific risk, that is, the alpha forecast accuracy. Hence, this activity of moving finds between styles is concerned with the
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objective of guaranteeing that the aggregate portfolio achieves its required risk- return target. Evidence of fund managers straying from their declared investment style has been documented in several studies. Brown and Harlow (2002) propose that the motivation behind style drift is driven by fund managers’ desire to chase short-term outperformance over their rivals and to attract new asset flows and earn greater income for themselves.
Although fund aggregation or drift presumes that separate fund managers hold superior stock-picking skills in their specific areas of expertise, this method comes with its own perils. Dawe et al. (2014) argue that since the portfolio of the drifting fund is now weighted with assets belonging to other styles, the portfolio is exposed to inappropriate levels of risk resulting in an unexpected risk/return trade-off for the fund holders. As a consequence, Dawe et al. (2014) forms the impression that style drift brings about an unexpected utility loss to investors and potentially results in a real economic loss in extreme market conditions.
Kurniawan et al. (2011) observe that the habit of drifting amongst American mutual funds is so severe that investor advocacy groups and financial planning professionals in the US took the stance of petitioning the Securities Exchange Commission (SEC). These groups advocated that the SEC require mutual funds to disclose complete portfolio holdings more frequently with the aim of exposing any style drift in an effort to protect investors. According to DiBartolomeo and Witkowski (1997), style consistency is an important component in enabling a concentrated manager to create a blended portfolio with the ex-ante desired risk-return characteristics. For example, if managers tilt their portfolios away from stocks declared in their self-stated style specialisation, then this may lead to an increase in potentially diversifiable risk in the overall portfolio. Fowler et al. (2010) remark that such actions can lead to the extent that the managers’ active positions may correlate highly with other managers.
Frijns et al. (2013) observe that style drift could, thus, have harmful effects on the underlying fund’s risk, performance and other fund characteristics. They therefore suggest that a fund manager’s self-stated investment mandate should accurately project information to the investor about the actual internal management of the portfolio. The Sharpe (1992) asset class factor (RBSA) model is often prominent in
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discussions of consistency, style drift, definition and measurement of a fund’s style.
In examining style consistency and drift, the R2 value from a regression of a fund’s returns against style benchmarks and the resultant error term from the model are normally used. However, some studies, e.g. Grinblatt and Titman (1992), (Andreu et al., 2009), Wermers (2000), Chan et al. (2002) and Baker et al. (2010) employ holdings based multi factor models (highlighted in the previous section) in measuring drift and these methods make use of rolling window graphs. These graphs aid in observing the change in composition of the portfolio over time, through adding subsequent returns as they accrue while dropping the same number of earlier data points.
The main drawback, though, of the holdings based approach is that, in most cases, information on actual mutual fund holdings is not readily available (Andreu et al., 2009). In addition to that, mutual fund portfolio holdings are ordinarily only available on a quarterly basis, hence, timely information on holdings may prove burdensome to obtain (Das and Uma Rao, 2013). Therefore, Kaplan (2003) argues that, if mutual fund managers carry out window dressing practices, inferences from reported portfolio holdings might be deceptive. As an alternative, Idzorek and Bertsch (2004) propose a different model for measuring drift called the Style Drift Score (SDS) whose premises are grounded on Sharpe’s (1992) style analysis model. From the resultant regression of Sharpe’s (1992) RBSA model, the square root of the sum of the average variances of each asset class coefficient defines measure of drift of any fund.
Wermers (2000) investigates style drift from the holdings based portfolio management perspective, through breaking down drift into both passive and active constituents. He found that more consistent managers (style-disciplined) were outperformed by their less style-consistent counterparts (drifters). However, the findings note that the managers as a grouping permit the portfolio’s composition to drift over time rather than engage in active trading to preserve a given style orientation. Wermers (2000), and Herrmann and Scholz (2013), confirm the widely held opinion that funds’ active trading, in reality, increases a portfolio’s drift. Chan et al. (2002) show that funds can display constancy in their stated styles through using the correlation among factor loadings over time from the Fama and French (1992) three-factor model. From separate comparisons of the size and value-growth
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dimensions, Chan et al. (2002) and Jansson et al. (2011) observe that those funds that appear to drift away from their stated styles are the underperforming funds.
Consequently, this has notable implications for multiple manager portfolio structures.
From their discovery that managers are largely unsuccessful in timing their styles, Chan et al. (2002) recommend that style drift is an inevitable fund trait that requires monitoring.
Contrary to this, Lau (2007) and Hsu (2014) observe that style consistency is not primarily a necessity for a portfolio manager for delivering performance, but rather suggests style rotation as a viable alternative that can improve returns. Cao (2012) examined hedge funds in the US for consistency and discovered that style consistent funds do not necessarily beat funds that exhibit less style consistency. The theoretical work of Barberis and Shleifer (2003) and Massa and Zhang (2009) contributes some intuition on whether style drift indeed enhances value to investors or not. They initiate a model of style investing with implications that stocks which change styles frequently are more probable to display price behaviours comparable to their new style cohorts. Therefore, Massa and Zhang (2009) allege that, if fund managers do not modify their holdings timeously and appropriately, then their portfolios will start drifting away from their present style orientation.
Chen and Wermers (2005) and Van Gelderen and Huij (2014), support the notion of enhancing returns based on the style drift perspective of investing. In examining the style movement of individual stocks, that is, the shifting of stocks between style categories, Chen and Wermers (2005) report that such stocks attain superior returns in relation to their style-matched benchmarks. From a consistency point of view, their finding is very significant, since style migration gives rise to drift. Thus, Verbeek and Wang (2013) deduce that the style of a fund will tilt if fund managers do not adjust their portfolio on time. Style drift may, therefore, be considered reasonable on such grounds, in order to realize the superior yields exhibited by these high style-shifting stocks. Style drift may also be considered plausible under variable economic cycles since different stocks perform differently with any slight or marked variation in the economy (Lai and Lau, 2010)
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