Style Drifting: Does It Add Value for Actively Managed Small-Cap Funds?
Larry Swedroe Mar 29, 2016
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?”
Analyzing the Literature
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 Bottom Line
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