Style Drift in Hedge Funds

When it comes to style drift in hedge funds, there is a lot of confusion as to what the term actually means. Investors and traders need to understand how this can affect their investments. In order to help you better protect yourself, we will be providing some useful information on this topic

We'll go over some key points about style drift that should give you a good grasp on this subject matter and get you ready for the rest of the blog post!

What is Style Drift

When discussing style drift in hedge funds a good place to start is by defining the term itself. Style drift occurs when an investment portfolio's allocation is modified over time. Style drift may result in a portfolio's assets becoming more or less aggressive than it was designed to be, violating the expectations of investors.

Style drift can occur naturally in a portfolio due to gains from certain assets and losses on others. A fund can also change if the investment manager changes or abandons the portfolio’s strategy.

Usually, a portfolio manager's commitment to managing a fund's assets according to its stated investment style over several years is a key point of differentiation between funds. Historically, even the most actively managed hedge funds and other investment strategies have been able to withstand some style drift without affecting long-term performance.

However, research has shown that extreme cases of style drift do affect fund returns and risk measures, especially over several years, as well as investor withdrawals from the fund.

What are Hedge Funds

Hedge funds typically make more money with less risk, thanks to a portfolio of investments that uses different types of investment methods and assets.

Hedge funds are not regulated by the SEC, so they are usually only available for accredited investors who qualify. Hedge funds are also offshore to some extent since they don't have to comply with SEC regulations. One aspect of hedge funds that has set them apart is the fact that they face less regulation than other investment tools like mutual funds.

What is Style Drift in Hedge Funds

Style drift is a phenomenon in which hedge fund strategies change over time due to changes in the economy, asset prices, and market trends. The effects of style drift can have a significant impact on performance and risk measures for an investment portfolio.

Style drift is one of the major issues for Hedge managers. Style drift typically begins small and evolves into more complex changes. Some managers may be able to avoid style drift by investing broadly and observing position limits. They can change their strategies and investment instrument to tune into the trends of changes in the market.

Does Style Drift Affect Performance

YES! Style drift can negatively affect performance if the manager loses control over their investment strategy due to any of the factors mentioned above. Hedge fund investors need to understand the strategies of their managers and the purpose their funds serve to maintain a healthy relationship.

Does Style Drift Affect Risks

YES! Style drift affects risks due to several factors that are listed below:

Inappropriate asset allocation: If a portfolio's assets don't match its stated allocation; this would affect the risk profile of the portfolio.

The passing of time: Over a period of time as a result of a change in market conditions, assets become riskier. The performance and allocation are no longer at par with what is expected from the strategy.

Over Concentration: If an investor holds too much in one asset; it can create unnecessary risk.

Under Concentration: If an investor holds too little in one asset it can create a significant loss due to lack of diversification.

Conclusion

As you can tell by now, style drift can have an impact on a portfolio's risk, returns, and volatility. Therefore, it is vital to understand the investment style of your portfolio manager throughout the period of time you're invested in the fund. The effects of style drift are amplified by severe and drastic changes over a long period. However, changes that are gradual and less drastic can have a more limited effect on the portfolio's returns. The bottom line is that style drift affects risk by creating problems with asset allocation, the timing of trades, concentration levels in a fund.

Originally Published Here: Style Drift in Hedge Funds