Catching the Drift: Legal and Practical Considerations for Hedge Fund Managers Who Deviate from Their Stated Investment Strategy

Strategy shifts, or style drift, in which a manager deviates from the fund’s disclosed investment strategy, can occur for any number of reasons, under a variety of circumstances and to varying degrees of materiality. Managers, however, must exercise caution when venturing outside the stated parameters of their fund’s investment strategy since style drift can open a manager up to regulatory sanctions, investor redemptions and civil litigation. At a minimum, if the style drift is significant or material, it should be disclosed to investors and may require an update to the fund’s governing documents and regulatory filings, such as Forms ADV and PF.

This article outlines what constitutes strategy drift along with some of its potential causes and which type of managers are most concerned with style drift; highlights why investors (and regulators) are concerned about style drift and how they monitor for it; and lays out best practices for how managers can internally monitor style drift and proactively and reactively manage any instances of material style drift.

What is Style Drift?

There is no set definition of “style drift” or “strategy drift.” Instead, style drift can be loosely defined as deviating away from the intended investment strategy of a fund explained in the hedge fund’s offering documents, which typically lay out a broad investment strategy that managers can deploy at their discretion.

According to Victor Zimmerman, a partner at Curtis, Mallet-Prevost, Colt & Mosle, “Style drift is really a question of fact. You always have to be thinking about how the regulators view it and how they would make the decision that your documents are now materially misleading in some way because of the style drift. You have to look at how much you’ve deviated from what you’ve told investors.”

To further illustrate what constitutes style drift, Bao Nguyen, director of risk advisory services with Kaufman Rossin, explained, “If a fund is set up to trade in commodities and now they’re buying real estate, that’s obviously a huge drift. If you’re talking about a large cap manager who’s disclosing the fund may participate in certain small cap investments to hedge, that may not be style drift as long as that potential drift is disclosed.”

What Causes Style Drift?

Macroeconomic factors, such as severe volatility or a lack of liquidity, can change the characteristics of certain assets which can, in turn, lead to a deviation in a fund’s investment profile. In most cases, though, manager actions, whether deliberate or inadvertent, and a desire to correct course, account for the strategy shift.

According to Nguyen, managers may drift from their stated strategy for a couple of reasons. “They may drift to protect on the downside, meaning they have a strategy in mind, but the market is going in a different direction, and the manager has to change the strategy in order to limit the fund’s losses. Conversely, if the manager sees an opportunity, he may change his strategy slightly to take advantage of that opportunity in order to meet the expected returns. Style drift allows the manager to change with the market in order to achieve returns and/or limit losses.”

And not all strategy drift is equal. There can be varying degrees of style drift, noted Michelle Chopper, a director at Arthur Bell CPAs. “Different strategies may lend themselves to a greater likelihood of style drift. For example, if the strategy is focused on small cap investments, then it’s easier for those to drift as market capitalization changes.”

Fund Strategy Disclosures in Offering Documents

Typically, funds’ offering memoranda outline the investment strategy or strategies funds will employ. According to John Hunt, a partner in Sullivan & Worcester’s investment management group, “Generally, most hedge fund documents have been drafted very broadly, so that even if they describe a very specific strategy, there is always wording that gives the manager the authority to execute the strategy how he or she sees fit and to be able to take advantage of the best opportunities available. There are often descriptions in the offering documents as to matters of leverage, the universe of securities the manager is going to be investing in and sometimes specific restrictions on concentration in particular sectors or particular types of securities.”

The provisions of the offering memorandum outlining a fund’s strategy are typically written capaciously enough to accommodate some managerial discretion to seek investment opportunities outside the stated strategy, as long as those investments are in the best interest of the fund. While the offering documents tend to be more high-level, the hedge fund marketing materials may include additional details about the fund strategy, such as leverage limits, debt exposure, geographic concentrations and concentration limitations, asset types or industries.

According to Chopper, “The governing documents usually have a lot more flexibility within them. They’re pretty broad in defining what the strategy is. We see more detailed and precise disclosure within the marketing materials and presentations to investors in order to supplement that very broad document. It’s a challenge to balance the different level of explanation between the marketing materials and the governing documents. Managers are spending a lot of time making sure they have transparent and consistent communication within those marketing materials and in any oral presentations to investors to make sure they are not giving any misleading information. It helps to discuss how ideas are being generated, what the research process is like and how they think about portfolio construction, and not so much about the specific types of instruments the manager will invest in.”

“Usually the offering memorandum gives a more expansive mandate and gives the manager discretion to go a little bit outside the stated style,” Zimmermann added. “Managers are pretty careful about making sure there is that discretion to vary the style outlined in the offering memorandum. The problem is that the marketing materials are often pretty narrowly focused and don’t have the same expansive interpretation of the investment style. That can pin down a manager and cause the perception that the manager materially deviated from the style outlined in the marketing materials, even if the drift is not outside what is stated in the offering memorandum.”

Finally, Nguyen noted, “The fund offering documents are normally kept very general, but the marketing materials provided to investors tend to have a little bit more detail about what exactly the fund will be doing. That’s where the exposure is, not only from a compliance standpoint but from a litigation standpoint as well.”

Verbal statements about a hedge fund’s investment strategy made to investors during meetings with a fund’s consultants or marketers are also considered investment strategy representations. As Zimmermann explained, “Oral representations can constitute part of the statement of a fund’s strategy and could influence an investor’s decision to invest with a fund. As such, managers need to be careful not to make any representations in meetings that are not supported by and consistent with the fund’s offering documents.”

Characteristics of Managers Most Concerned with Style Drift

There may or may not be a great deal of concern for style drift depending on the fund’s size and/or the amount of leeway given to managers to execute a fund’s strategy. For instance, larger institutional managers tend to have more discretion to deploy their funds’ strategies, so style drift is not a significant issue for them. Other managers, on the other hand, may be more likely to deviate from their stated strategy.

According to Zimmermann, “Style drift may be more important to some managers than others. The managers who are really successful and don’t have a problem raising assets can probably draft broader documents and give themselves a little more discretion in executing the fund strategy. Newer managers with less of a track record don’t have the ability to give themselves the same degree of discretion, so their documents have to be more focused and set forth their strategy in more detail. They will be more concerned as to whether there is style drift.”

Chopper added, “Oftentimes, newer managers are trying to establish a great track record, and they may not have sophisticated processes in place yet to curb against style drift, so the motivation to chase returns and take advantage of opportunities outside their given strategy is greater.”

As more founding partners at established hedge fund managers retire, the transitioning of investment teams and other executives can also lead to style drift. As Chopper explained, “Succession can also cause style drift. As managers grow or turn over the reins of investment decision making to new portfolio managers, it may result in some style drift because every portfolio manager brings their own view of the markets and expertise to the role.”

Investors’ Style Drift Considerations: Materiality, Notification and Ongoing Due Diligence

Materiality

For hedge funds that deviate from their stated strategy, the materiality of the style drift is key to determining when and what notifications must be made to investors.

In determining materiality, Zimmermann said some factors include: whether the new strategy being pursued is riskier than the original strategy, whether the manager has the experience to pursue the new strategy and what percentage of the fund will be pursuing the new strategy.

Depending on how much discretion the fund’s governing documents give the managers, there may be no need to alert investors to any style drift that is not material. As Hunt explained, “If the governing fund documents give you some latitude in deploying your investment strategy, there may not be anything the manager has to do except to respond to any investor inquiries about the style drift, if the investors raise any concerns. If you breach your stated investment guidelines materially, sometimes the offering documents will outline the steps the manager has to take in response to that, whether it be to simply notify investors, allow them to redeem, give the manager so many days to get back into compliance or update the governing documents.”

The fund’s governing documents and agreements with investors, including side letter agreements, will also dictate at what point managers should notify investors of style drift. “The timing of a manager’s notification to investors will depend on the contract established with the investors, the specificity of their mandate and the strategy,” Chopper noted. “If these were narrowly defined, you could materially drift pretty quickly, and swift communication is appropriate. If more broadly defined, the manager may have more latitude in the amount of time to correct and communicate. I believe it is in the best interest of the manager to communicate more frequently with their investors, especially to share their research and investment philosophy and how that correlates to the way they’ve constructed the portfolio.” (For more on common side letter terms, see “Trends and Practical Considerations for Negotiating and Implementing Investor Side Letters in the Current Environment (Part One of Three)”)

When determining when and how to notify investors, managers should note that some investors may be more accepting of style drift, Zimmermann stated. “Acceptable levels of style drift depend on the relationship you have with the investors. If an investor has a long history with the manager and knows there are occasional variances from the stated style, then they’re aware of potential style drift and may be a little more accepting of the instances where it happens.”

In addition to notifying investors due to legal and regulatory obligations, managers are wise to communicate with investors as a simple matter of trust. Ranjan Bhaduri, chief research officer at Sigma Analysis & Management, explained further, “Style drift creates an issue of trust. If a manager is deviating from what they said they would be doing, then an investor loses trust in the manager. If there is no trust, then an investor has no reason to stay with a manager and that could lead to a redemption by the investor.”

The consequences of style drift include regulatory sanctions and civil litigation. Deviating from a fund’s stated strategy can open a fund up to civil action by an investor or regulator alleging misrepresentation in the governing documents. From a general regulatory standpoint, material style drift without consent from or proper notification to investors is akin to fraud. A material misrepresentation under rule 10b-5 also could lead the SEC to, at the very least, issue a deficiency letter at the end of an examination, refer the issue to the Division of Enforcement or refer the issue to the U.S. Attorney’s Office for criminal action.

“Materiality is ultimately something that is up to the SEC to decide,” Zimmermann explained. “There is the general 10b-5 standard of materiality that the SEC has set forth, which is that [a strategy drift is material] if the disclosure of a fact would cause a reasonable investor to either sell the investment or make an investment based on that information.”

How Investors Monitor for Style Drift

Aside from the practical implications of a manager’s style drift, changing investment focus can substantially alter the risk profile of underlying investors’ portfolios. Todd Peters, co-founder and director of research at Lyndhurst Investment Partners, explained, “Strategy drift has always been a significant focus for investors and the due diligence community, particularly when you’re dealing with institutional investors or anyone that is investing significant assets. These investors are often using more than one manager, and they are trying to pair managers together in a complementary fashion and not have too many managers doing the same thing. Investors and those in the due diligence community are studying the investment approach and how the investment manager implements that approach to set an expectation. They’re looking at the specific types of companies the manager invests in, the characteristics of those companies, how the manager trades around those companies and risk management techniques to essentially create a profile of expectations. Investors are expecting managers to adhere to that profile because that profile helps the investors build its entire portfolio of managers.”

Peters added, “When a manager deviates from the given profile, it doesn’t only impact the specific manager, but it throws off the structure of the entire portfolio. Regardless of the flexibility the manager may have, at the end of the day, there are very specific considerations that investors use to make their investment decisions. As a due diligence person, you spend a lot of time analyzing and getting comfortable with the given strategy and profile of the manager, and you expect they will stay true to that. When there is strategy drift, it has ramifications and multiple levels, and that’s why investors are focused on it.”

Bhaduri concurred, adding that “Investors are looking for a diversified set of managers, a diversified set of drivers and a diversified set of assets, and if an underlying manager starts doing things that are completely different than what they stated they would do, then the whole portfolio construction collapses.”

As investors in the current financial environment are trying to better define their allocations to hedge funds, they are increasingly focused on style drift. “In recent years, sophisticated and large institutional investors have tried to fit hedge funds within more precise buckets so they do not find themselves overly concentrated in certain strategies, markets or asset types,” Hunt said. “They are now less tolerant of managers that drift outside of their described investment strategy because of that, and because that may mean they are taking much bigger risks than what they originally intended. So, we’re now seeing investors looking for managers to have very precise investment strategies outlined in their governing documents to try to prevent style drift and over-concentration in certain areas.”

There are a variety of factors investors use to evaluate whether their portfolio is at risk for style drift, or whether it has already occurred, including evaluating prior funds the manager has run. Investors will also look at specific investments of the current fund, even if on a delayed basis, to see if they match the stated investment strategy. Hunt also pointed out that investors are asking for notifications more frequently when managers drift outside of their stated investment parameters, and they will ask for short redemption windows where there is unacceptable style drift. “Institutional investors are getting at least quarterly reports, but many are asking for more granular reports on the fund portfolio,” Hunt said. “They will look at those reports the manager provides and try to determine if the manager is staying within the parameters of the investment strategy and, if there is style drift, if it is at an acceptable level.”

Added Chopper, “How investors monitor for style drift depends on the size and sophistication of the investor. We’re seeing large institutional investors with full teams of individuals performing ongoing due diligence and analysis based on the tremendous amount of reporting and transparency they require from managers. Investors want to also make sure they have a holistic view of their investment portfolio so that they are well diversified and can report that back to their boards and stakeholders.”

Chopper said one operational red flag for investors trying to detect style drift is to look out for managers who are launching new funds that may include new strategies. “Investors will want to understand the controls in place to run multiple strategies in parallel without introducing style drift when investment opportunities with short term gain potential may be available but outside the parameters established by one of the funds. Other clues which should be well explained include the opening of offices in other countries or hiring new personnel that have different expertise from what is expected for the type of strategy the manager was currently deploying.”

Investors are also keeping an eye out for aberrational performance as an indicator of style drift, Peters said. “Strategy drift can be determined, to an extent, by performance. If you expect a strategy to perform a certain way in a given environment and the returns come in different than those expectations, that’s a red flag. For the most part, strategy drift comes from analyzing the holdings and the transactions, so you need access to the portfolio holdings, at least on some reasonable time frame, in order to do the proper analysis of how true the manager is staying to what the manager said he would do.”

How to Address Accusations of Style Drift

When investors indicate they believe style drift has occurred, managers must respond appropriately, but exactly how a manager responds to accusations of style drift will vary. According to Zimmermann, “Your response depends on whether you want the investor to remain in the fund and what the accusation is. If you think the investor will become a thorn in the side of the manager, the manager could redeem the investor and let them out of the fund.”

“If the manager is contacted by an investor about perceived style drift, the manager first has to determine if they agree with the analysis or just substantiate their investment decisions to the investors,” Chopper advised. “If they are confronted, managers need to consider the investor’s perspective. A manager is just one piece of that investor’s portfolio, so think about what the manager’s impact would be to the overall portfolio of that investor so they can work together to decide next steps to remedy the situation—whether that means incorporating new policies, enhancing communications with the investor or redeeming that investor.”

From the investor’s and due diligence analyst’s perspectives, Peters said, “The first thing to do when strategy drift is detected, assuming there is a good relationship with the manager, is to call the manager to ask about it and talk through the situation. The options then are to do nothing about it, if the explanation is acceptable or it is a one-off situation, although the manager may be watched from that point for more instances of strategy drift or other red flags, or the investor can redeem from the fund if they are uncomfortable with the change and the reasons for it.”

Whenever an investor approaches a manager about a problem, it is important that key executives within the firm are made aware of the issue so it can be addressed, Nguyen said. “If there is a complaint, managers should speak with the compliance officer and look at the options for addressing the issue. You should also contact counsel to discuss the appropriate ways to address it. If the investor thinks style drift has occurred and doesn’t agree with the change, perhaps the simplest response is to allow the investor to redeem.”

In dealing with accusations of style drift, Peters noted, “Communication is key. It’s not a matter of communicating after strategy drift has been discovered but communicating proactively with investors about investment opportunities that may fall outside of the disclosed strategy. Besides identifying a potential opportunity, you also want to demonstrate to your investors that you have the expertise to take advantage of that opportunity and see it through. You have to justify the opportunity and that you have the internal expertise that can prove out the thesis. You can send out letters but something like this should be done through calls to your client base to explain the situation and allow for questions.”

Bhaduri added, “Sophisticated investors understand that there can be alpha decay and that hedge fund managers are continuously researching new investment opportunities. Following on this research, a hedge fund manager may choose to trade a new instrument or make a new kind of trade. There is an expectation that hedge fund managers will adapt and evolve over time and investors do not want to impede that progress. The important thing for managers is to just communicate these changes to the investors and explain the rationale behind them. Investors have come to expect a fair amount of transparency and communication in advance of an implementation of a new model or new style or sub-strategy. The problems arise when that doesn’t happen.”

Monitoring For or Preventing Style Drift

There are several key steps a hedge fund manager can take to guard against allegations of strategy drift. One method is to draft the strategy section of governing documents broadly enough so that managers have a great deal of latitude to pursue a wide range of strategies or variations in strategies.

In monitoring for style drift, Chopper advised, “It’s important that managers have oversight and review controls in place in the investment process, including the performance of quantitative analysis to dissect risk-adjusted returns relative to carefully selected benchmarks or indexes. Holdings-based analysis should also be made readily available to investors to assist in evaluating drift.”

Added Zimmermann, “To monitor for or prevent style drift, I think that’s a combination of risk management, legal and compliance acting together to regularly review documents and policies to try to see where the investment strategy can go down the road and making sure the documents give the manager as much flexibility as possible to take advantage of opportunities.”

“Risk management should be looking at what the fund documents state and at the investments regularly to make sure in all cases the manager is still complying with what was disclosed in the offering materials,” Zimmermann continued. “If it looks like they’re not, then compliance and legal needs to get involved to make sure the documents are updated and investors are notified that there has been a decision to change the strategy and give investors an opportunity to redeem if they do not agree with the change.”

Technology can also be employed to monitor for style drift. According to Hunt, “Most investment managers will have computers systems to track all of the portfolio positions so they can build into those systems risk parameters and investments guidelines so managers can try to detect any style drift and manage their portfolios.”

Where a manager wishes to pursue investment opportunities that are outside its stated strategy, but wishes to avoid style drift in its fund, a more labor-intensive strategy is to launch a new fund to pursue the new fund strategy. Nguyen cautioned though that, “Creating a new fund takes time. If a manager is going to deviate from what’s in the offering documents, we recommend they at least send out a negative consent letter. Give investors a window to speak with the manager and ask questions before making changes. Allow them to redeem if they disagree.”

Chopper added, “Open communication between the manager and investors is especially important when market conditions have changed in some way which significantly impacts the strategy and, as a result, consideration may be given to pursuing opportunities in another area. There have been instances of managers closing funds because the current market will not deliver alpha, and the cost of maintaining a fund during those times can’t be justified. Managers should consider whether it would be necessary to open another fund or give investors the opportunity to consent to allow deviation from the original strategy. Managers can expect investors to redeem if changes don’t fit their mandate.”

Perhaps the best method to guard against allegations of strategy drift is to simply solicit consent from investors for any new investment that arguably is outside of the strategy as stated in the governing documents. According to Zimmermann, “If the new strategy will deviate materially from the stated strategy, then ideally you should obtain investor consent through whatever vote is necessary under your governing documents.”

Style drift can also be avoided, or at least mitigated, during the marketing process as well. Where investors rely on representations made during the fundraising period, managers need to make proper disclosures to investors that the fund’s governing documents should be the source of any information about the fund strategy or its terms. Zimmermann said, “Managers will sometimes get representations from investors stating they will not rely on any terms or conditions outside of what’s stated in the offering materials. That’s usually in the subscription documents. As the marketing materials vary, which they often might, the manager can point back to the language in the offering documents and subscription documents to show there is no style drift. It might not stop a regulator from saying style drift has occurred or that the disclaimer was not bold enough or clear enough to let investors know to only rely on the strategy outlined in the offering materials [but it’s a start].”

Managers also can include sufficient cautionary language in marketing materials that they may rely on the bespeaks caution doctrine to protect them against liability for forward-looking statements about investment strategy. As to when managers rely on the bespeaks caution doctrine, Hunt said, “It really depends on who the offering documents are going to. If it’s large institutions who vet the offering materials carefully, then the doctrine may not really be necessary. If you have a high net worth investor who hasn’t thoroughly examined the offering documents and relies greatly on the sales pitch in the offering materials, then having the additional disclosure at the end of the materials, with the admonition that investors need to read the prospectus as that will outline the specific funds terms under which the manager will be operating, may be a good idea.”

Regulatory Focus on Style Drift

Regulators, namely the Securities and Exchange Commission, do not have a specific focus on style drift, but will look for evidence of it during examinations or will investigate complaints of style drift from investors. Regulators are mainly concerned that a particular deviation from stated investment strategy was not properly disclosed or that the manager has made misleading statements and/or committed fraud.

According to Chopper, “Regulators want to ensure that appropriate disclosure (both in terms of accuracy and adequacy) about the strategy has been made to the investors via the governing documents and regulatory filings. They will consider the manager’s ability to make investments outside the stated strategy and use data analytic tools to evaluate whether a manager is operating outside the boundaries and whether the manager has made sufficient additional notification and disclosure about these activities in communications with investors.”

Zimmermann added, “The SEC is interested in style drift because it becomes an issue of misleading investors. That’s their primary focus. The SEC is looking for evidence of style drift when they visit firms during their examinations. There may not necessarily be an enforcement action that stems from the style drift, but the SEC may say that managers need to update their offering documents and notify investors. It could be listed in a deficiency letter as something that needs to be addressed.”

“We haven’t seen the SEC come in and accuse hedge fund managers of their fund documents being too general,” Nguyen observed. “The problem is often that the fund governing documents are general, but the marketing materials say the manager will do X,Y and Z, and the strategy is completely different from that. The SEC has a problem where the manager is deviating from what is in the marketing materials provided to clients. Another issue could be where the manager is drifting to and if that creates any potential conflicts with other investments, or if there is a business reason for the drift that should be disclosed.”

Regulators are also looking at disclosures made regarding the investment strategy and the manager’s ability to deviate from it. Where changes are made to the strategy and the fund’s governing documents have been updated to reflect that, the fund’s Form ADV should also be updated to reflect the changes and ensure an accurate description of the strategy and how it’s being deployed.

Regarding the regulatory concern, Zimmermann said, “While investors may be more accepting, regulators are really only going to look at whether you materially deviated from the strategy you disclosed to investors. If there is material style drift, the manager should be updating its offering documents to reflect that and notifying investors of the change in strategy and giving them an opportunity to redeem.”

He added, “If the SEC felt the style drift was egregious or there were already investor complaints about it, then it could be referred to Enforcement for further action. Outside of the SEC’s focus, fund managers also have to be careful that the style drift isn’t so dramatic that investors take legal action. Intentional and egregious style drift can open the fund manager up to civil litigation from investors.”