The Shrouded Business of Style Drift in Active Mutual Funds

Abstract

This study investigates the motivation and performance consequence of intentional style drift in an exclusively in-house fund management industry in China. With style drift, fund investors are exposed to investment portfolio outside their risk-return preference but are generally unaware that their risk and return expectations are disrupted, and the functioning of the fund market undermined. Our study provides evidence for the first time about the incentive that motivates style drift behavior. We find that style drift increases a fund’s subsequent net inflows, thus affirming the maximization of AUM-linked compensation as the motivation for fund manager’s style drift behavior. We also find that larger funds have greater incentive to drift. We demonstrate that style drift behavior interferes with the picking of quality stocks to deliver fund performance for fund investors. Style drift as an unobserved risk behavior harms fund investor interest and undermines market integrity.

Keywords: Style drift, Mutual funds, Holdings-based analysis, Stock picking, Compensation design, Risk-taking incentive

JEL Classification: G11, G14, G23, N25