We are often asked about active versus passive wealth management approaches. One question that can be confusing is that of style drift. What is it? How can it affect my financial planning?
It’s no secret that we’re not big fans of the active management approach, in which a financial advisor or fund manager buys and sells positions in an effort to generate extra returns. We not only believe this is ineffective; there is also scant evidence to support the notion that trying to beat the market works any better than blind luck.
In our opinion, active management should not be part of a sound wealth management strategy. But even putting all of the other well-documented problems of active management aside, the issue of style drift is enough to lead a rational investor to reject the active management approach as a viable alternative. Here’s why.
How Does Style Drift Affect Investment Planning?
A mutual fund operates within certain boundaries, which are defined in its prospectus or investment policy statement. However, a prospectus is usually written in such as way as to give portfolio managers a maximum amount of flexibility – so much flexibility, in fact, that we like to compare reading many funds’ stated objectives to reading a horoscope in the daily paper. In essence, they’re simply providing vague invitations to engage in wishful thinking.
While the words may sound official, technical (and binding), for all practical purposes, a portfolio manager can pursue virtually any strategy she desires. She can switch from a value strategy to a growth strategy, or shift from large companies to small companies. Significantly, she can also generate whatever rate of (useless) portfolio turnover she desires.
Is Your Investment Professional a Bit too Footloose and Fancy-Free?
Why do managers have so much leeway? Because limits and restrictions run counter to the basic philosophy of active management. After all, why would anyone want to hamstring this talented manager by placing constraints on her? If she can pick winners, don’t clip her wings – let her soar! (Cue the orchestra)
Sounds great, right? Maybe in theory. In reality, the free hand exercised by portfolio managers leads to a problem known as style drift, along with higher trading costs and turnover. Conscientious, rational investors build portfolios according to certain criteria such as small, medium, large, growth, blend or value. So what happens when the mutual fund they’ve so carefully chosen changes its approach and applies a new, different criteria for stock selection?
Say you decided to get a dog. As a responsible pet owner, you research breeds until you find the absolute best dog for your specific lifestyle. Say you get a dachshund, and you’re very happy with your choice. Suddenly, a year later, you wake up one morning and your little dog has morphed into a Great Dane. That’s the reality of style drift.
The Implications of Style Drift on Strategic Financial Planning
In essence, style drift renders strategic wealth planning somewhat moot. You can’t design and implement a logical, consistent investment plan using active management.
When managers play it free and loose with your portfolio, you can easily end up with considerable overlap among the various funds in your portfolio, which diminishes diversification. Style drift makes effective and lasting asset allocation – otherwise known as the single most important step investors take to achieve efficient diversification – impossible to achieve. And when you can’t control diversification, you can’t manage risk.
In contrast, passively managed index funds or structured asset class funds that are managed in a disciplined manner can dramatically reduce or eliminate style drift and keep your comprehensive financial plan on track. Once you’ve allocated your assets amongst classes, your allocation will remain true to its original blueprint. Once you’ve set your course, you’ll stay there.