WealthManagement Magazine

Drifting Styles

There are two ways to view mutual fund style drift.The first is that it's a headache. Just when you've got a client's portfolio appropriately diversified, the portfolio's funds begin creeping in different directions. The big-cap fund chases performance into small-cap stocks. The small-cap fund goes heavy on high-tech stocks, replicating the technology fund the client already owns. And the growth fund

There are two ways to view mutual fund style drift.

The first is that it's a headache. Just when you've got a client's portfolio appropriately diversified, the portfolio's funds begin creeping in different directions. The big-cap fund chases performance into small-cap stocks. The small-cap fund goes heavy on high-tech stocks, replicating the technology fund the client already owns. And the growth fund turns out to be--surprise!--a value fund.

As a result of style drift, the client's portfolio suffers. Allocations change, performance can slip, and risk can rise. Can you say pass the Tylenol(Registered Trade Mark), please?

Yet, this migraine of a problem is also an opportunity.

"Style drift is one of the best ways to demonstrate to a client the value of what a professional brings to the equation," says Don Phillips, president of Morningstar in Chicago. "This is the kind of work that is very difficult for an investor to do on their own."

It's no secret that many individual investors buy their mutual funds based solely on performance. "Anyone can pick up Money magazine and pick a four- or five-star mutual fund," says Larry Parker, manager of Legg Mason's Nashville, Tenn., office. "But, there's a lot more to it than that."

Tracking mutual funds and style drift has become an industry unto itself, as evidenced by the increasingly complicated ways companies such as Morningstar, CDA Wiesenberger, Lipper and Value Line analyze funds. Although this analysis can be complex, there are still four basic questions a rep should always be asking of any mutual fund:

1) Is the fund behaving in a manner that is consistent with other funds of the same type? If not, the fund may have drifted.

Research outfits watch for drift by tracking performance against an accurate benchmark. For example, Legg Mason's two-year-old mutual fund research division examines 8,300 funds as part of its research for a fee-based program called Mutual Solutions. Ultimately, Legg Mason makes an educated guess at a fund's contents by comparing the fund's performance to 12 benchmarks (such as the S&P 500) over rolling 24-month periods. Tracking against benchmarks warns against style drift, and also provides an indication of how a fund is allocated. Legg Mason's research division correctly concluded that a large and popular fund was sitting on a lot of cash during a raging bull market, claims Mark Seaman, research director--and explained its lag.

"This doesn't identify the hot fund of the quarter, nor are we looking for the funds that perform above average compared to their peer groups," says Seaman. "We wanted to find funds that perform consistently, especially in market downturns."

2) How big is the mutual fund? Many funds have grown exponentially in the last decade and their investments may change as they grow. Be especially wary of hot funds that attract huge inflows. Size isn't necessarily bad, but large cash holdings can put pressure on managers and force style changes.

"There are not many managers consciously trying to deceive people," says Phillips. "But I don't think you can examine the fund at just one point in time." Instead, he suggests looking in detail at the portfolio every now and then so you have a sense of how the fund is evolving.

3) What exactly is the fund invested in? Here's where all the computer tools freeze up. While research products can show asset allocations and top holdings, the information is often dated and not specific. Nothing adds value as much as a rep who knows exactly what a fund is doing. Stay in touch with wholesalers and fund companies. Check periodic portfolio reports for major shifts in positions and industry allocations. And look at the actual securities a fund's manager is holding--it'll give you a feel for what a fund is doing well beyond what your pure quant competitors can offer.

4) Who is running the fund? This is, perhaps, the most important question. Legg Mason has determined that style drift most often occurs when there's a change in a fund's management.

"Two different people often have different investing methods--maybe one likes derivatives and the other makes sector bets," says Seaman. "This affects the fund's style."

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