Investors choose mutual funds based on their investment objectives. In pursuit of said objectives, they can choose from among the broader asset classes (such as stocks and bonds) with additional, more specialized options available within each class. These decisions are important because they determine the amount of exposure an investor has to specific types of risk (for example, the risks of small versus large stocks and value versus growth stocks).

An issue for investors selecting actively managed mutual funds is that, while such funds specify their investment objectives in their prospectuses, there is no guarantee they follow their self-stated investment strategies. In fact, many active managers believe that their ability to drift across styles provides them with an advantage. However, if managers deviate from their stated style, they expose investors to unanticipated risks.

The question for investors is: does the evidence demonstrate that active managers are able to take advantage of the opportunity that style drifting provides, or is it the case that the ability to style drift is one “fraught with opportunity?”

Charles Cao, Peter Iliev and Raisa Velthuis contribute to the academic evidence on the ability of active managers to exploit mispricings through their March 2016 paper, Style Drift: Evidence from Small-Cap Mutual Funds. The authors hypothesized: “Small-cap focused funds provide an ideal setting to assess the prevalence and consequences of style drift behavior. Small-cap fund objectives are clearly defined compared to other fund objectives and therefore provide the benchmark of small-cap funds is not ambiguous. In contrast, funds focusing on growth or value stocks have strategies based on vague terms, open to interpretation by the manager.”

They note that since March 2001, SEC regulations require that mutual funds invest at least 80% of assets according to the investment objective implied by their names. Prior to 2001, the regulation specified an allocation of 65% to the implied investment strategy. The authors used The Center for Research in Security Prices (CRSP) Survivor-Bias-Free U.S. Mutual Fund Database and covered the period from 1995 through 2010. The study included more than 600 small-cap funds. The following is a summary of their findings:

• On average, small-cap funds allocated 27% of their net asset value to mid- and large-cap stocks (defined as Russell 1000 constituents), peaking at 35%. Their allocation to non-small-cap stocks, on average, was in excess of 20% in every year following 2000. However, exposure to non-small-cap stocks could reach as high as 67%, more than triple the SEC rule of 20% maximum exposure.

• The tendency to hold mid- and large-cap stocks is persistent over time at the fund level, suggesting that certain types of funds employ this strategy.

• The top decile of funds holds in excess of 60% of their portfolio in mid- and large-cap companies. These funds potentially mislead investors under the impression that they are investing in a “properly behaving” small-cap fund.

• Larger and older mutual funds are more likely to hold large stocks.

• Fund flows in the previous year are negatively related to the large-cap proportion of the fund holdings. This result doesn’t support the hypothesis that funds invest in large-cap stocks as a result of capacity constraints due to increased fund size.

• On average, the sample of funds had an expense ratio of 1.4% and a turnover ratio of 116% per year.

• Small-cap funds investing in mid- and large-cap stocks don’t deliver superior performance (based on a four-factor model consisting of beta, size, value and momentum) relative to the small-cap funds that refrain from investing in large-cap stocks. This holds true over the entire sample period, 1995 through 2010, as well as the full sample period excluding the technology bubble.

• Small-cap funds that have higher allocations to larger stocks don’t exhibit persistence in performance over time, nor do they exhibit more persistence in performance relative to small-cap funds that have lower allocations to larger stocks.

The authors concluded that large deviations from fund objectives did not lead to superior out-of-sample performance over their entire sample period, and that their study underscores the importance of careful research when choosing a fund. In other words, style drifting doesn’t generate alpha, but it does expose investors to unanticipated/uncontrolled risks.

For investors, it’s important to understand that style drift entails unexpected risks, risks that can undermine their strategic portfolio allocation. And the evidence also shows that while investors in funds that style drifted incurred higher fees, those higher fees didn’t translate into superior performance.