There are many wonderful things about mutual funds. For example:
They offer instant diversification into many different securities.
They relieve you of the responsibility of deciding which securities to buy, when to buy, and when to sell.
They can have brilliant money managers working on your behalf, trying to make you richer.
Still, all isn't completely perfect in the mutual fund world. Let's say, for example, that you're investing in managed mutual funds, where managers actively decide what to buy and sell, as opposed to index funds, which simply and passively hold the contents of a given index. That's often a good thing to do, as some such funds (albeit the minority) have great track records of beating the market handily over many years. Despite the advantages of managed funds, however, there's a dark side: They sometimes change over time.
How funds change
Basically, the mutual fund you sign up for may not be the fund you end up with some years down the road. In fact, it may not even be the fund you think it is on the day you buy. For example, look at the FBR Small Cap (FBRVX) fund, which I recently bought into. If you expect it to deliver mainly small-cap holdings to you, you're wrong. According to Morningstar, it's really a mid-cap fund, and has been one since at least 2005. The average market cap of its top holdings is around $3.5 billion, and they include AES (NYSE: AES ) , with a market cap around $12 billion; CarMax (NYSE: KMX ) , at $5 billion; and D.R. Horton (NYSE: DHI ) , also around $5 billion.
The "small-cap" fund recently held 16% of its assets in large-cap stocks, 49% in mid caps, and almost 35% in small and micro caps. (Note that the fund managers are aware of this discrepancy and plan to change the name of the fund to FBR Focus soon.) As another example, look at the DFA U.S. Large Cap Value (DFLVX) fund, which recently had 31% of its assets in mid caps.
If you're wondering how this happens, it's not necessarily sneakiness on the part of fund managers. With small-cap and mid-cap funds, it can be a sign of success. If a fund buys into many smaller companies and holds on for the long haul while they grow, it likely will end up holding many larger companies. After all, successful small companies do tend to become bigger companies.
Another way a fund can change is when its managers drift away from the investment approach or style they lay out in the fund's prospectus.
Here's one way this can happen: If a fund focuses on small companies, and does so successfully, it will sport a strong record. That will likely attract more investors with more money. As the fund grows, the managers will have to find many more places to park all that money. Remember now that it's most effective to have your money invested only in your best ideas. If the managers have loaded up on all they can of their best ideas (small companies, in which you can't invest too much money without risking influencing the stock price), they'll have to start investing in second-tier places.
Another way it can happen is when a fund isn't doing well and hasn't been doing well for a while. The managers may then abandon their approach to some degree, trying to find better investments. For example, a "value" fund, where the managers are expected to patiently invest in stocks deemed undervalued, may experience an exodus of impatient shareholders. In response, its managers might start loading up on high-flying stocks, in the hope of quickly improving performance.
What to do
So what should you do about style drift in your holdings? Well, at least be on the lookout for it. Know that it can sometimes be OK -- such as when a good fund is still doing very well for you, despite drifting a bit. For example, according to Morningstar, the Delafield (DEFIX) fund has drifted over the past few years from being mainly a mid-cap value fund to a mid-cap fund blending value and growth (this is not a major drift). Its performance is still strong, though, averaging annual gains of 15% over the past three years and 18% over the past five. Its top holdings recently included Thermo Fisher Scientific (NYSE: TMO ) , Flextronics (Nasdaq: FLEX ) , Honeywell (NYSE: HON ) , and International Rectifier (NYSE: IRF ) .
But if a particular drift seems more desperate in nature, or if it's changing the character of an investment too much for you, consider selling. If you want to rid yourself of style drift worries entirely, stick with index funds.
In the meantime, as you evaluate various funds as candidates for your money, be sure to include an assessment of their style, how it fits your needs and how it's changed over time. (Morningstar's fund reports recap funds' styles over the past few years.) We'd love to help you find some great funds through our Motley Fool Champion Funds newsletter. Try it for free for 30 days -- I suspect you'll like what you see.