Anatomy of "style drift"

Previously, such as in this post, we have discussed the problem that is common to "mass-managed money" which is the fact that as they grow larger and larger, they are forced to own more and more securities -- and if they invest in equities, they are forced to own shares in larger and larger corporations.

The fact is that most investors in the United States, including ultra-wealthy investors, get their exposure to equities through what we call mass-managed money (money managers who are managing portfolios that exceed $5 billion dollars). In other words, the primary way that these investors connect to the ownership of businesses is through vehicles that are forced, by their sheer size, to own shares in hundreds of businesses, and to own shares in a very specific type of business: LARGE businesses.

This is because mass-managed money is not just a mutual fund phenomenon. Many wealthier investors use managed separate portfolios -- a form of managed money that does not pool the investments of different account-holders into one fund, but keeps them separate. We explain some aspects of separate portfolios in our publication Separate Portfolio Advantages, available here. But although the separate portfolio structure has many advantages over the mutual fund structure, especially for wealthier investors, most of the managers of separate portfolios are huge mutual fund companies who offer separate portfolios that may have more dollars under management than their mutual funds do! Many well-known separate portfolio strategies have upwards of $10 billion under management.

The diagram above is an illustration of what can happen inside a portfolio strategy (whether it is a mutual fund or a separate portfolio strategy) when it grows into the tens of billions of dollars in assets. The diagram shows the famous Fidelity Magellan fund, from mid-1982 through early-2000, and graphs its holdings by the SIZE of the assets. The different colors on the chart represent percentages of the holdings that are in stocks characterized as small-cap value or growth, and large-cap value or growth. This chart can be found on the internet in a Barclays Global Investors research paper entitled "In Pursuit of Performance: the Greatest Return Stories Ever Told" (see page 18 of the document).

Note that in the early years of the fund, before it began to grow to massive proportions, the portfolio was primarily composed of stocks characterized as small-cap growth:

In this part of the graph, the lightest-colored section (making up more than 50% of the holdings) designates small-cap growth stocks, while the darker blue section above it represents small-cap value stocks, and the gray at the bottom represents large-cap growth stocks. This is the composition of the fund at the left side (earlier years) of the portfolio.

Fifteen years later, however, the right side of the timeline shows a radical change in the composition of the fund:

Note that by the end of the period under consideration, large-cap stocks (the gray area at the bottom of the diagram) have grown to consume over 80% of the portfolio's stock holdings. Small-cap growth stocks, the lightest of the four colors in the graph at left, used to be the largest portion of the portfolio, but by this slice in time they have been squeezed down to a sliver, and by the end of 1999 they were entirely absent from any meaningful role in the portfolio. By the very end, the lowest color band on the chart (large-cap growth) and the second-lowest band (large-cap value) make up almost the entire portfolio, except for the thin (and shrinking) band at the very top representing the remaining small-cap value stocks. In other words, the record shows a very strong migration of the portfolio from owning stocks in smaller-cap companies to owning almost entirely stocks in large-cap companies. What happened in the intervening years that caused such a transformation in the types of companies that investors held? The fund grew enormously. This X-ray of a "mass-managed" fund emphasizes the points we made in our previous posting (linked at the beginning of this post) about larger funds (or portfolios) being forced into larger stocks. It also reveals the fact that investors may have the same investment vehicle for many years, but that does not mean that they are getting the same portfolio management consistently for all those years: the management team may change their style, or the management team may leave altogether! In short, these diagrams present a picture of "style drift" that is forced upon many investment vehicles as they grow larger and larger. Investors need consistency not just for a couple years but for many decades (the chart covers almost twenty years -- most investors don't think about it, but their need for exposure to equities over their investing lifetime will be usually be even longer than twenty years). Consistency is very difficult to find in today's landscape, which is dominated by mass-managed money and Wall Street salesforces which use mass-managed money as their main investment tool for their clients.

For later posts on this same topic, see also:

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