Beware of style drift in mutual funds

Facebook’s recent initial public offering revealed more than the fact that a hot company need not necessarily be a hot stock. As The Wall Street Journal reported last week, a surprisingly diverse group of mutual funds lined up for Facebook Inc. shares. More surprising and potentially disturbing for financial advisers and their clients is that many of the funds, given their ostensible investment goals, shouldn’t have bought the stock at all.

For example, a dividend growth fund bought Facebook shares, though the company doesn’t pay a dividend.

Additionally, a good number of value funds bought shares even though Facebook isn’t considered a value stock.

Advisers need to keep a close eye out for style drift among the funds that they entrust with their clients’ hard-earned savings.

To be sure, a little bit of style drift is normal. Midcap companies, for example, grow up to become large-cap companies, usually resulting in a nice little profit for those who held on to them through their growth spurt.

But too much style drift is a strong indication that a fund’s manager, or managers, have veered away from a fund’s stated investment objective. Style drift also may point to a change in leadership of a fund’s management team or a lack of conviction by the manager in a fund’s investment philosophy.

Finally, excessive style drift also may indicate a manager’s propensity to chase returns — which is anathema to many advisers and planners.

The fact that such a diverse group of funds invested in Facebook demonstrates the wide latitude that is afforded to mutual fund managers and should serve as a reminder to advisers that they must do their due diligence when reading the prospectus for each of the funds that they are looking to buy for their clients.

LOOKING AT LEEWAY

Advisers must take the time in their research to see how much leeway a fund manager is allowed in terms of how he or she can invest the fund’s assets, and take that into account when determining asset allocation.

A study by the Association for Investment Management and Research — going back a few years but still relevant — found that about 40% of actively managed funds were classified inaccurately or had drifted from their stated style.

For advisers and their clients, style drift is dangerous because it may lead them to think that they are invested in one particular asset class when, in fact, they are invested in another.

Style drift also leads to insufficient diversification as a result of having funds that overlap.

The best way to check for overlap is to find the top holdings in the mutual funds and compare them with an overlap detection program, according to industry experts. Overlapping exposures are then segregated by individual equities, sector weightings and by country.

Finally, too much style drift leads to inappropriate levels of risk for a client.

Advisers and their clients have every right to expect fund managers to adhere to their funds’ stated investment mandates. And they are right to punish managers who abandon their mandates by withdrawing assets from their funds.

Although some shifts in management style may be unavoidable over short periods of time, it is the fund manager’s job to keep the overall mutual fund investment portfolio in line with the intended objectives.

And it is the adviser’s or planner’s job to hold them to it.

Therefore, a style drift investment review should become part of a broader, more comprehensive investment review strategy on a quarterly basis. By doing so, advisers can confidentially assure their clients that what was invested in initially is still accurately represented in the underlying investment holdings.