Style Drift

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21 Aug, 2024

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Style drift is a concept in financial investment that signifies an investment manager's deviation from the initially stated investment style. This deviation may cause a change in the portfolio's risk and returns profile. It may also create a significant impact on the portfolio's performance and its earnings.

This drift may result in substantial consequences for the investor. It may lead to a mismatch in the investor's financial goals and risk tolerance. Moreover, the portfolio may underperform due to the alterations. Furthermore, it may lead to an inconsistency in the portfolio performance.

What Is Style Drift?

Style drift is a financial investing concept that indicates an investment manager's diversion from the initially stated investment style.
It could lead to a discrepancy or incompatibility in the investor's financial goals and risk tolerance.
Investment managers may recognize new market possibilities and problems. They may alter their initial investment style to adjust to those changes, resulting in this drift.
However, investors can avoid drift by establishing specific investment criteria that outline the acceptable divergence from the initial investment style.

Style Drift Explained

Style drift is a term in financial investment that refers to an investment manager's divergence from the initially specified investment style. This divergence can modify the portfolio's risk and return characteristics. The performance and earnings of the portfolio could also be substantially affected by this diversion.

The investor could face significant repercussions as a result of this drift. It may trigger a conflict or misalignment in the investor's risk tolerance and financial objectives. Additionally, the changes may cause the portfolio to underperform. Moreover, it might cause the performance of the portfolio to fluctuate. Investors who aim to adhere to a consistent investing strategy must take this drift into account. Taking proactive steps to identify and fix the drift will enable investors to stay on track with their financial goals.

Factors

The factors that can influence an investment style drift are:

The change in market conditions may result in this drift. The portfolio may modify its investment strategies to accommodate the changing market dynamics.
Investment managers may recognize new opportunities and challenges in the market. In an attempt to adapt to those changes, they might change the stated investment style, resulting in this drift.
The drift may occur due to a change in the investment manager's objectives, approach, or philosophy.
The manager may conduct a portfolio rebalancing to manage the desired risk and return attributes, leading to this drift.

How To Identify?

Some methods to identify investment style drift are as follows:

An investor may constantly monitor the consistency in the portfolio manager's style to ensure that there is no deviation from the stated investment style. They must periodically assess the portfolio holdings and their performance, which will help reflect any changes in the portfolio's composition.
They may also employ performance metrics to identify any drift in the investment style. The metrics will enable an investor to compare the performance against the established benchmarks and reveal if there are any discrepancies or deviations due to this drift.
The investor must closely track any changes in the investment management team, as a change in the investment manager may result in this drift.

How To Avoid?

The strategies to avoid a style drift are:

Investors may avoid drift by setting up clear investment guidelines that display the admissible diversion from the initial investment style. They must also communicate these guidelines to the investment manager to ensure transparency.
The investor must regularly communicate with the portfolio manager to stay informed about the manager's strategies. It will help them identify any change or drift in the investment style.
An investor may conduct portfolio reviews periodically to identify and address any drift. They should assess the portfolio's performance, associated risks, and holdings to ensure that the portfolio is aligned with their risk tolerance, goals, and objectives.

Examples

Let us study the following examples to understand this drift:

Example #1

Suppose Amy wanted to invest her money, and so she sought help from Sam, an investment manager. Initially, Sam would choose to invest in large-cap value funds based on Amy's financial objectives and her risk tolerance. However, he gradually started shifting toward investing in small-cap growth stocks. This change in the investing approach increased volatility and exposure to small-cap stocks, which was contrary to Amy's initial investment goals. This is an example of style drift.

Example #2

Comparing equity valuations involves a lot of effort and is a time-consuming process. However, it must be done at frequent intervals because the industry average is constantly changing, which affects the equity an investor owns and how it compares to the average. This article suggests that investment can no longer be done only by looking at a style box or fund name. To prevent a style drift or a complete misinterpretation of how the money is being handled, investors must now delve deeper into the fund's holdings or the investment decisions that they are making.

Benefits

A style drift may indicate a potential for a portfolio's enhanced performance. The investment manager may change the investment style and strategies according to the prevailing market conditions. Since the markets are dynamic and volatile, a versatile approach may enable the manager to keep up pace with the market changes and adapt according to the changing business environment.
The drift may also allow the investment manager to identify new opportunities in the market and customize the portfolio accordingly to capitalize on those opportunities. As a result, there may be newer avenues that the manager can portfolio, resulting in enhanced performance and increased returns.

Risks

Some style drift risks include the following:

The drift may leave investors vulnerable to unanticipated investment risks. The investment manager's change in decisions may not take into account the investor's financial objectives and risk tolerance capacity. This diversion may increase the portfolio's volatility and result in inadequate investment outcomes.
This drift may influence the diversification in the portfolio as a change in style may significantly divert the intended portfolio into an imbalanced or excessively concentrated portfolio. The lack of diversification may increase the portfolio risk and reduce its performance in the long run.
A significant style drift risk is that the drift can make it difficult for investors to assess the investment manager's expertise and performance precisely. The drift from the original portfolio may make it challenging for investors to identify if the performance is a result of the manager's skills or the drift in investment style.

Frequently Asked Questions (FAQs)

How can style drift be monitored?

There are several ways in which an investor can monitor this drift and conduct a style drift analysis. However, regression analysis is the most common method they use to evaluate the exact amount and kinds of risk that a fund endured over a specified period. It goes through the fund's historical returns to perform a style drift analysis and evaluate the changes that occurred and its associated risks.

What are common types of style drift in portfolios?

Some common types of this drift include sector drift, size drift, geographic drift, drifts within asset classes, and manager drift. Sector drift takes place when the portfolio allocation to various sectors diverts substantially from its initial benchmark. Size drift signifies the diversions taking place in a portfolio to a different market capitalization segment. Geographic drift indicates that a portfolio's allocation has diverted to different geographic locations from its intended plan. The drift can take place within different asset classes like fixed income or equity. A manager drift occurs when there is a change in the portfolio managers.

What is the role of investor diligence in managing style drift?

Due diligence is a structured method that investors employ to assess and minimize the potential risks from an investment decision. It enables an investor to detect any drift in the investment style and study the deviations in allocation in the investment fund.