As fashion icon Coco Chanel once said, ‘Fashion fades – only style remains the same.’
While these words were in reference to the world of haute couture, they apply surprisingly well to portfolio management too.
In a highly competitive industry increasingly pressured by fee compression and the shift to passive investing, high-conviction active managers who stick to their style look more likely to endure than trend-chasing drifters with less well-defined processes or philosophies.
But telling the two apart is not always as simple as it should be. Every manager and gatekeeper will have a different definition of style drift and will monitor for it in different ways.
While the Morningstar style box provides one standardized measure, it is also a broad-based approach – by design – which lacks the nuance required by some analysts.
But while it’s all well and good knocking someone else’s efforts, what are gatekeepers doing instead? How do they define style drift, and when does it really start to matter?
Scott Welch, chief investment officer at Dynasty Financial Partners (below), believes that style drift occurs when a portfolio manager begins to engage in trades or positions that are out of alignment with the people, philosophy and process of a stated investment strategy.
‘A simple example might be a large-cap value manager that suddenly begins to take on growth stocks or small-cap stocks in an attempt to drive performance,’ Welch said. ‘In such an example, the deviation might work for a while, but that success is likely to be transient because the manager has exhibited no historical skill in those other investment styles. It is likely an exercise in “chasing the hot dot,” which inevitably will, at some point, no longer be the “hot dot.”’
Welch added that while style drift mattered, some managers may be able to deploy an investment approach that works equally well in different market segments, such as in both large caps and small caps. Likewise, others may have a mandate to move around the style spectrum as they identify opportunities.
‘So, style drift in and of itself is neither bad nor good, if that’s the stated investment philosophy up-front and can be evaluated accordingly,’ Welch said. ‘When it may become a problem is when it occurs without discussion with the due diligence professionals, outside of the investment mandate for which the manager was hired.’
Anna Snider, head of due diligence for the chief investment office within Bank of America’s global wealth and investment management division (below), echoed this sentiment, arguing that the significance of style drift depended on the reason why the manager was hired in the first place.
‘Style drift in the monitoring process is important because it removes the ability for the advisor or portfolio manager to rely on the strategy to get a certain market, factor or other type of exposure,’ she said. ‘Even if the manager ends up benefiting from investing in opportunities outside of their universe, it’s still not the experience the client signed up for.’
Pure and simple
Kevin Sullivan, senior investment research analyst at Wells Fargo Investment Institute, agreed that it was important to watch for style drift, but added that more flexibility should be allowed these days, as there are fewer and fewer ‘pure style managers’ around.
‘I think it really starts with how you define your manager and what expectations you have for them. When we embark on searches and look to add managers to this platform, we’ve got a very clear mandate on what we are looking for,’ Sullivan said.
‘A style-pure manager may be exactly what we are looking for, and that’s great. But we may be looking for a manager that provides a little bit more flexibility, a little more opportunity to reach into the corners of the style box and even beyond the corners of the style box to achieve the objectives that we have for that specific mandate,’ he added.
Sullivan said that the global manager research team at Wells Fargo uses both the Morningstar style box and its own separate analyses to identify style drift. The team carries out a quarterly review to examine performance outliers both on the upside and the downside, as well as a semi-annual process where they do a deep dive on the holdings and returns of all the managers in a particular sector.
Ellie Chizmarova, managing director of investment research at Beacon Pointe, has a similar due diligence process for spotting style drifters.
‘We believe that style drift can manifest itself in two ways: performance results that deviate from expectations and portfolio holdings that are inconsistent with the investment manager’s stated philosophy and approach,’ she said. ‘As part of our due diligence process, we closely monitor both factors, and any red flags we identify may lead to a decision to place a manager on a watch list or to recommend termination.’
As harmful as style drifters can be for the overall portfolio, in practice gatekeepers often choose to be patient with the managers and funds they own.
One of them is Tom Thornton, head of manager research at Raymond James Asset Management Services (below), who oversees 100 home-office discretionary model portfolios with $50 billion in assets.
‘Drift to me can be found in correlation over time, betas that change, traditional styles such as large blend drifting to large growth, or factors in the portfolio that are not as consistent as you thought,’ he said. ‘In other words, drift can come from performance patterns or from actual holdings, so we scrutinize the past as much as we can. We look at rolling correlations with benchmarks and regressions versus various indices and peers using past monthly and quarterly returns.’
To avoid and minimize style drifters’ impact on portfolios, Thornton and his team spend a vast amount of time looking at each strategy’s fit in the portfolios – whether that’s active, passive or in a separately managed account.
‘In practice, with our passive portions we typically stick to market cap-weighted high-volume ETFs to make sure there’s no drift there. With active, we will monitor the drift and if it hurts our portfolio return and risk expectations we will move on,’ he said.
While some consider style drifters to be undisciplined or cheating to win, Bob Boyda, senior portfolio manager at Manulife (below), has a different view.
Boyda believes that style drift is more a matter of the people and process involved in an investment strategy than it is about a specific outcome or set of indicators, which after all could be picked up by a mechanical style analyzer.
‘Because we are all intelligent, adaptable human beings, we look at style drift as “I expect my manager to be constantly looking for new ideas, new ways of thinking, and very slowly incorporating new thought processes into their investment style, investment program and investment approaches,”’ he said.
‘What I don’t expect is ever to get a step function change where someone immediately says “You know what, we just decided to move from stock picking to quantitative management.” That would be a step way too far.’
Alper Daglioglu, head of Global Investment Manager Analysis at Morgan Stanley Wealth Management, agreed with Boyda that not all style drift was an issue.
'Style drift also could be part of the DNA for certain strategies, certain strategies you hire them not for a certain style, it’s a little bit more opportunistic across the board and we take this into account when we conduct due diligence,' he said. 'An example of that is an unconstrained bond fund, [they] tend to invest across the curve, [have] actively managed duration, credit risk or other counter risk or even currency risk, as they see opportunities that an investment-grade bond fund cannot. We know that investing in an unconstrained bond manager is an exception.'
'You have to be a little bit open-minded, knowing that markets evolve. You cannot just think about style drift as a kind of black-and-white schema. You cannot just rely on the pure quantitative analysis, the art part is also important, you want to be intellectually honest and confident about your analysis. Overall, you've got to really think about what the investment strategy is and how you are using that investment strategy in your portfolio.'
Boyda added that to spot and avoid true style drift, any good investment analyst overseeing a manager or strategy should have a fairly solid knowledge of all the major positions that are in the portfolio, which could then help them to spot whether the manager’s rationale for putting new names in leading positions has deviated significantly over the course of a year or two.
‘It requires the analyst to have a good understanding of the companies that are actually in the portfolio,’ Boyda said. ‘Hopefully, that doesn’t come as a shock to people: That if you are good at overseeing managers, you are actually pretty good at investing yourself and you actually have an understanding of the effect that they are having on a name-by-name basis.’