Are Your Investment Portfolios “Drifting”?– June 28, 2018 by Michelle Chopper

We’re in the swing of vacation season! For many, that may include some “drifting” (a.k.a. drifting asleep poolside listening to Jimi Hendrix croon about drifting on a lifeboat to see his love). A drifting investment portfolio, however, is anything but welcome vacation material.
 
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 generally achieved by combining investments with less-than-perfectly correlated investment styles and effectively monitoring risk.
 
Style drift occurs when a fund deviates from its stated investment style or objective. As a result, investors may no longer have the well-diversified portfolio they expect. It is an important function of a fund manager’s role, and to a certain extent a responsibility of an investor, to monitor investment portfolios for “style drift” to understand if and when it is happening — and, importantly, how to prevent it.

Winds of Change

Whether you are an investor or a fund manager, how can you identify whether the stated objectives are being delivered in a given portfolio or whether it has, in fact, drifted?
 
Most investment professionals agree that style drift is more likely to occur in an actively managed portfolio rather than a passive portfolio. However, index or mutual funds and ETFs are not immune to style drift. By understanding the risk factors and potential causes of style drifts, investors and managers can develop controls for detecting, monitoring and preventing them.
 
The typical reasons for style drift include: 

  • Poor style market performance,
  • Mismatch in the asset 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 an investor’s due diligence process, any tendencies toward style drift can be uncovered by evaluating how a manager reacted to any of the above situations in the past. For existing managers in a portfolio, ongoing communication will help investors identify when these events are happening so they can discuss how the manager is responding and whether there will be an impact to the portfolio. However, keep in mind that sometimes what may appear as drifting may actually be an appropriate reaction by the manager to adjust (and possibly correct) the portfolio for new market conditions. Communication is a two-way street. Investors can appreciate these adjustments when a manager clearly articulates his thinking and views on current market conditions and how his response corresponds to their strategy and objectives.
 
In addition to communication, investors also rely upon transparency, often involving an extensive amount of data, for the detection and monitoring of manager activities. Institutional investors continue to make investments in technology and data management programs to meet their fiduciary responsibility and cope with increasing regulation. Managers and fund 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. 

No Drift Zone

So what can be done with this data in an effort to thwart style drift? Investors can 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 (often 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 analyses help open the door to an effective dialogue between investor and manager.
 
Holdings-based analysis also may help accelerate the detection of style drift, although position-level detail has traditionally been more difficult to obtain or to manage if an investor has limited resources. Investors can 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 will need to be evaluated when developing the best approach to detection and monitoring. At a minimum, investors and managers should have the necessary information and tools available to them to accurately report the portfolio risk introduced by the style drift.

The Secret Sauce (Governance)

But it’s important 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 meant to give investors one of the key protections they deserve:  guarantees that investments are managed in accordance with the stated investment objectives.
 
So what are the red flags when evaluating managers for effective fund governance? Corporate culture can provide many clues as to whether a style drift issue may lie ahead. Corporate culture is manifested in the following: 

  • 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? Is she 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 can help provide an effective control against style drift. When drifting is deemed to be appropriate, managers would be wise to present the risks associated with their investment guidelines versus the risks associated with their current allocations to demonstrate the depth of their risk-management practices.
 
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 use their 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.
 
And then perhaps you can sit back and relax, leaving the “drifting” for vacation ... while on a lifeboat sailing for home. 

Please contact a member of your service team, or contact Michelle Chopper at michelle.chopper@cohencpa.com for further discussion.
  

Cohen & Company is not rendering legal, accounting or other professional advice. Information contained in this post is considered accurate as of the date of publishing. Any action taken based on information in this blog should be taken only after a detailed review of the specific facts, circumstances and current law.