Investors: catch their style drift?
It’s no secret that investors want a well-diversified portfolio that produces consistent returns through all kinds of market cycles and fits within a mandated or expected risk profile and parameters. This is achieved by combining investments with less than perfectly correlated investment styles and by effectively monitoring risk. Monitoring investment mangers for style drift is an important function to managing one’s investment portfolio. Style drift occurs when a fund manager deviates from its stated investment style or objective. As a result, investors no longer have the well-diversified portfolio they expect. So how can you identify those fund managers that will deliver on their stated objectives–or more accurately–how can you identify and steer clear of those managers that are not likely to deliver?
By understanding the risk factors and potential causes of style drift, you can develop controls for detecting, monitoring, and preventing style drift. The typical reasons for style drift include poor style market performance, mismatch in the assets flows and capacity of the strategy, weak manager performance or drawdowns, changes in key investment personnel, and changes in the market structure or regulatory environment. During the due diligence process, you can uncover any tendencies toward style drift by evaluating how a manager reacted to any of these situations in the past. For existing managers in the portfolio, ongoing communication will help you identify when these events are happening so you can discuss how the manager is responding and whether there will be an impact to the portfolio.
In addition to communication, investors rely upon transparency, often involving an extensive amount of data, for the detection and monitoring of manager activities. Institutional investors have made significant investments in technology and data management programs to meet their fiduciary responsibility and to cope with increasing regulation. Managers and administrators have adapted with similar investments in technology so they can slice and dice the fund’s data in any number of ways and provide real-time data access to investors. So what can you do with this data in your efforts to thwart style drift?
Investors usually perform a returns-based or holdings-based analysis to understand a manager’s investment activities:
Returns-based analysis may include a time series analysis where a fund’s performance is compared to the stated investment objective in terms of risk, return, and correlation with predefined asset classes and benchmarks. The extent of style drift can be measured by the extent of changes in the sensitivities of the fund’s returns to asset class index returns. Another option is performance attribution analysis to determine where performance is coming from and comparing exposure trends between managers of the same style. Comparing managers against their peers in exactly the same market environment can shed light on style drifts (generally if there is underperformance with respect to peers) or abnormal risk levels (oftentimes when there is over performance with respect to peers). There could be other reasonable explanations for why a fund may have inconsistent alignment with its benchmark or peers, and these types of analysis help open the door to an effective dialogue between the investor and the manager.
Holdings-based analysis may also help accelerate the detection of style drift, although position level detail has traditionally been more difficult to obtain or to manage if you have limited resources. Investors check if a manager’s positions conflict with the strategy, or if the positions look like a different strategy altogether.
All of these methods have their strengths and limitations which need to be evaluated when developing the best approach to detection and monitoring for you.
But we need to take a step back and look beyond just crunching numbers. Philosophically (and perhaps scientifically), there is a correlation between fund governance measures and reduction in style drift. Effective fund governance should provide the system of checks and balances which are meant to give investors one of the key protections they deserve: guarantees that investments are managed in accordance with the investment objectives. So what are the red flags when evaluating managers for effective fund governance? Have you noticed the phrase “corporate culture” popping up lately? If so, it may be because a regulatory body or enforcement organization is paying close attention to a firm’s culture.
- Fund focus: Is the manager focused on investing or gathering assets? How much time and money are devoted to each of these activities?
- Investment processes and controls: Is the process repeatable? Risk-aware?
- Technology: Is the manager committed to deploying technology to adapt to new demands? Are they using technology to support and enhance compliance processes?
- Expertise: Do individuals have the appropriate skills in fulfilling their fiduciary responsibilities?
- Interaction with investors: Are there adequate levels of transparency and communication?
- Working environment: Are there employee retention issues? Do people stay? Why do they leave?
Managers with a well-defined and well-articulated culture of compliance should have effective controls for the prevention of style drift.
Investors want superior, long-term, risk-adjusted performance and believe it can be achieved by consistently investing in asset classes mandated by the fund’s investment objective. And managers want to utilize their unique skills to deliver that performance. Open communication, transparency, data analysis, and a culture of compliance will help investors and managers work together to employ these and other methods to catch style drift, optimally before it becomes a problem.
Michelle Chopper is a Director at Arthur Bell CPAs and is responsible for managing the Consulting & Advisory team at the firm, and advises on operational infrastructure, financial reporting, risk management, and business valuation.