BUSINESSWEEK INVESTOR

Spotting ‘Style Creep’

When a fund starts to wander, returns can suffer

If you own shares in Legg Mason Value Trust, you probably aren’t complaining. After all, the mutual fund has beaten 99% of its peers over the past five years in total return. But if high-flying technology stocks continue to slide, you may feel some pain. Why? Although the fund has »value» in its name, it also owns several high-octane stocks more commonly found in growth-style portfolios, including AOL (AOL ), IBM (IBM ), and Dell Computer (DELL ).

For all of its virtues, Legg Mason Value Trust illustrates what’s known as style creep—an unflattering term applied to mutual funds that wander outside their advertised areas of expertise. Chasing today’s winners to keep up with their benchmark indexes, managers realize, can improve a fund’s returns. But the practice can also hurt investors by leaving their portfolios dangerously concentrated in today’s favored investment style and underexposed to tomorrow’s. This can undermine your ability to reduce risk by building a diversified portfolio. Let’s say you have an asset-allocation plan that puts 50% of your nest-egg into mid-cap stocks. But thanks to an errant mid-cap manager, 75% is now in large caps instead. To rebalance your portfolio, you need to sell some of the mid-cap fund’s shares, possibly incurring capital gains taxes.

DIFFERENT ANIMALS. Style consistency matters for another reason, too. Managers who stuck to their styles had higher risk-adjusted returns than their more eclectic peers, according to figures for three five-year periods from 1992 to 1998 that fund tracker Morningstar crunched for Putnam, the Boston-based mutual-fund company. The results held true across all types of funds.

Like a growing number of fund companies, Putnam is sold on style consistency, which is why it regularly reviews portfolios and programs computers to highlight stock funds that drift out of their targeted areas. »If a fund is supposed to be a small-cap growth fund but has Microsoft, that will be called into question,» says Beth Cotner, chief investment officer of the large-cap growth group.

Still, some drift is inevitable. For instance, managers often buy stocks that fit their criteria, only to see market movements transform them into different animals entirely. Parnassus, which considers itself a mid-cap value fund, bought its largest holding, Intel (INTC ), when the semiconductor maker was selling in the 30s. Now that it has hit 69 3/8, Intel is »making us look like we’re going from value to growth,» says manager Jerome Dodson. Maybe that’s why Morningstar assigns the fund to its mid-cap growth group. Unless Intel’s sales, profits, or other fundamentals deteriorate, Dodson says, he may retain the stock until it hits $105—15% above what he figures is its true value.

Other victims of style creep are investors in small-stock funds that keep winners after their market values rise above $1.1 billion—a threshold Morningstar defines as mid-cap territory. (Fund trackers’ definitions differ; Standard & Poor’s, like BUSINESS WEEK a division of The McGraw-Hill Companies, calls Parnassus a small-cap growth fund.) »As long as we are confident in their prospects, we continue to hold them,» says Michael Fasciano, whose Fasciano Fund has remained small-cap despite mid-cap holdings including International Speedway.

If you spot style creep in your portfolio, the key question is whether to sell a fund, triggering possible tax and transaction costs. A little drift is O.K. »Don’t sweat having 1% more in mid-caps than you want,» says Russ Kinnel, senior fund analyst at Morningstar. But weed out funds that make big changes, as Fidelity’s flagship Magellan famously did in 1995, when it plowed 16.6% of its assets into bonds.

A recent study by S&P found that if a fund fluctuates between growth and value, shareholders can expect to see a big impact on returns. Over the past 15 years, the performance gap has averaged about 8 percentage points—with growth outpacing value in some years and the opposite occurring in other years. As you might expect, this is about twice the disparity between funds that adhere to one of the two styles and those that fall into a middle-ground classification Morningstar calls »blend.» Typically, fund-rating firms, such as Morningstar, S&P, and Reuters’ Lipper division, classify portfolios according to how expensive or cheap they are compared with similar indexes or funds. Growth funds are relatively pricey, blend funds are average, and value funds are bargains.

According to S&P, if your fund is one of the few that migrate between small- and large-cap, you can expect to see its performance move up or down by a dramatic 11.1 percentage points annually, on average. Over the past 15 years, vacillations between mid- and small-caps have resulted in an average gap of 7.9 percentage points, while moves from large- to mid-cap have produced a 5.6 point change.

For S&P, which tracks, rates, and recommends mutual funds, the upshot is clear: »We won’t get overly worried if we see a blend fund start to look growth-y or value-y,» says Rosanne Pane, a director in the fund services group. But when it comes to other changes, S&P might not be as forgiving. »If a fund is drifting to a style that is dramatically different, your potential returns, volatility, and risk are going to change,» she says.

To detect style drift, look up your mutual fund in the rankings published by S&P (www.personalwealth.com), Morningstar (www.morningstar.com), BUSINESS WEEK (www.businessweek.com/mutualfunds/investor/), or any other fund-tracking service. Morningstar looks at each fund’s holdings and—although the information is slighly dated—assigns it to one of nine squares in a »style box» that ranges from small-cap value to large-cap growth. (Lipper adds a multi-cap rating for funds that don’t adhere to one market segment.) If the historical pattern points to a wanderer, purists should steer clear.

To further aid investors, Morningstar averages monthly »style-box» results over three years. If the »category» rating that results differs from a fund’s current style-box designation, it’s another possible sign of drift. To probe beyond such labels, use the databases to research a fund’s holdings, current and past average price-earnings ratios, and weightings in industries and market-cap ranges. Warning bells should sound if Microsoft (MSFT ) pops up in a mid-cap portfolio or a tech-averse fund suddenly loads up on the sector.

You don’t have to avoid a fund just because it meanders. But to ensure proper diversification, construct a core portfolio of funds that will remain true to their stated approaches, and monitor them carefully. That will leave you room to take a flyer on a fund that continues to make money even if it strays from its chosen path.

By ANNE TERGESEN

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