Diversification – and its ability to reduce volatility – has been much trumpeted by many fund managers over the past couple of years.
Even the analysts at Barclays dedicated a chapter to the merits of diversification in the 2007 Equity Gilt Study report. The study, which is its annual examination of the returns of different asset classes throughout the decades, reiterated the importance of a diversified portfolio (see box).
The question is whether employees are familiar with the benefits of diversification – and more pertinently, whether they need to be.
It is a well-worn fact that many pensions investors simply opt for an equity fund, or in the corporate pension arena a default fund, which is typically an equity fund or old-style balanced fund with at least two-thirds of the portfolio in shares. But should employees care about volatility, and is there an answer to their prayers if the answer is in the affirmative?
“Absolutely they should,” says Robert Kingston at BDO Stoy Hayward. “We are moving away from DB schemes where the risk was on the pension plan, but the move towards DC and GPP arrangements has put the onus on the individuals. They are the ones taking on the investment risk, and if they don’t understand the risk they could end up with a smaller pension fund than they anticipated.”
The Hewitt 2007 DC Survey showed that the median DC scheme, which was just under £4 million in the 2006 DC Survey, had doubled to £8 million in 2007, and that two-thirds of all schemes now only offer DC as the sole provision of pension saving. Most of these have legacy DB arrangements in place are either closed to new members, contributions or future accruals.
“It appears that DC schemes may reduce some risks for the sponsors. However, for employees it brings much greater risk and responsibility, requiring a much deeper understanding of pensions and investment issues than for defined benefit,” says Simon Chinnery, head of institutional at JP Morgan. “Members need to appreciate the impact of the decisions that they are making today. If they are not aware, are they storing up problems for the future for them, the trustees and the sponsors?”
But risk and volatility are not the same – even though many experts reckon that the man on the street associates risk with losing money. A 25-year-old with a pension fund heavily exposed to bonds and cash is taking the risk of being too cautious. Volatility, on the other hand, can also open up opportunities.
“Risk and volatility are not the same thing,” says Pat Wynne at Xafinity. “If you have a long way to go to retirement, volatility is not a risk. If you are close to retirement and volatility is squeezed into a short period, then it is a risk. You also have the ‘reckless conservative’ who thinks he is reducing risk, when he is actually increasing it.”
Lifestyling has been traditionally deemed as the answer to reducing volatility, but many analysts question the wisdom of a wholesale shift out of equities into bonds.
Chris Nichols, investment director for strategic solutions, at Standard Life, believes that lifestyle funds let down pension investors at the very time they need exposure to riskier assets such as shares, because they begin to ditch them in favour of bonds. He calculates that people who move to a 60:40 fund in favour of bonds five years from retirement will be 10 per cent worse off after they pick up their golden watch, and 20 per cent worse off if they move wholesale into bonds.
Yet lifestyling continues to be the popular concept with DC schemes with nearly two-thirds of them offering it as the default option. The majority of lifestyle strategies – more than 80 per cent – are using a global equity fund for the growth phase of lifestyle.
Kingston argues that although lifestyling can reduce volatility, it can also remove the opportunity for growth. This pre-retirement phase is where the new breed of funds enter the fray – products that are seeking diversification, yet are trying to deliver equity returns with bond volatility. “That’s the perfect scenario,” says Julian Webb, head of DC business development at Fidelity.
New products offer diversification, from multi-asset funds to absolute return funds to packaged structured funds. The offerings come from groups such as M&G, Fidelity, JPM, Schroders and Cazenove.
“The problem is that a lot of members are too conservative by nature and miss out on the upside,” adds Webb. “Global equity funds were supposed to help, but they did not protect investors from the volatility.”
Consequently, Fidelity is set to launch a diversified growth plan in the next couple of months for the DC market. The fund will be similar to its Diversified Growth fund it launched for the DB market last summer.
Fidelity says that diversification works because different asset classes perform differently in different market conditions. Pension fund managers have traditionally combined equities and bonds because of their negative correlation, but this approach is not sufficiently sophisticated to generate the risk-and-return profile that pension schemes now need.
The DB fund is an unfettered multi-manager fund with exposure to a broad range of lowly-correlated asset classes through 29 underlying funds, spanning equities, bonds, and alternatives such as property, commodities, currency and funds of hedge funds. Fidelity boasts it is the most broadly diversified fund currently available to UK pension schemes, and has an investment target of 3.5 per cent over LIBOR.
To the naked eye, many of the so-called new asset plays such as private equity and commodities are volatile by nature and Schroders, which already has a diversified growth plan in the marketplace admits that many ‘diversifiers’ can be volatile.
For example, in 2000 – when listed equity markets began their painful slide – private equities, emerging market bonds, hedge funds and commodities were still able to deliver positive returns. Further into the equity bear market, while equities continued to fall in value, a few diversifiers – such as hedge funds, high yield bonds and emerging market debt – still provided positive, albeit modest, absolute returns.
“Diversifiers can at times be quite volatile, and therefore, held alone could be regarded as risky investments. However, because they often have low, and occasionally, negative correlation to mainstream asset classes, held as part of a diversified multi-asset portfolio these asset classes can serve to reduce risk and/or boost return because they often perform differently at key points in the cycle,” says Andrew Yeadon, head of multi manager at Schroders.
“Evidence like this leads us to conclude that, over time, a diversified approach to multi-asset investing can deliver an improved portfolio Sharpe Ratio (better return per unit of risk).”
Yeadon adds that the diversified approach is of little use if the consequence of applying it is only to spread a portfolio across a bunch of asset classes that are, at any particular point in time, either overvalued or about to become ‘return challenged’.
“We give greater emphasis to those asset classes that offer the most promising shorter term returns, while giving less emphasis – or zero weighting – to those that we believe are likely to fall short.”
The debate of whether some targeted return funds will deliver the goods is still up for debate. As we reported at the end of last year, many funds have failed to come to scratch during their short-life span and so far the take up is slow. But many advisers do believe they have a use – so long as they work. They will be useful for Sipps and drawdown, and are particularly useful for those looking for wealth preservation once they have accumulated their money.
“If you can grind out a return of 8 or 9 per cent per annum you will double your investment every 8 or 9 years. This is not a bad state of affairs,” says Mark Dampier, head of research at Hargreaves Lansdown. “However, from an investor’s point of view there is always a danger that these things fall between two stools. That is they are not ballsy enough in a good bull market for people to be interested, and then when people get fearful as they are now they desert everything to cash.”
Simon Chinnery, senior client adviser at JP Morgan doesn’t actually believe there is anything inherently wrong with the lifestyling model, but he believes that total return funds and diversified growth plans can work.
“It’s fine to have high equity content but members need more education. They get bumph when they join a scheme, but when they get their annual statement and see their fund has fallen in value, they do not understand why. The perception of risk and volatility is not faced by the member,” he says. “Trustees tend to offer a default fund and feel they have done their duty, but members are at a disadvantage because the market has moved. The new products offer greater common sense.”
Chinnery would like to see more web-based communications in the GPP market, where employees can log on and be interactive – to “get a feel of what is going on”.
It is an avenue that Wynne says works best with large companies who can afford to make the most of the costs. Xafinity delivers an ‘efficient frontier model’ that allows employees to look at ten different asset classes to calculate probability of returns and standard deviations – be it for equities, bonds, commercial property or hedge funds. “The problem is it is best suited to the sophisticated investor,” observes Wynne.
Volatility is an issue for all investors, and employers will always tend to shy away from a fund management style that leads to serious troughs, as well as peaks, in their staff’s pensions. As we all know, investors like making money, but they hate losing it even more, and if pensions are there to retain staff, then employers are clearly going to get more value out of a less volatile investment strategy, even though scheme members are benefiting from pound cost-averaging by regular saving – thereby reducing the risk of market fluctuations.
Evidence from the number crunchers does suggest that a diversified portfolio can reduce volatility – yet at the same time generate decent returns at least as good, if not better than non-diversified portfolios. The reality is that employees continue to tick the default box when they come to choose their workplace pension.
Therefore the onus is perhaps on trustees, employers and providers to do the job for them, and deliver on a plate the best funds of their class and those that give the member the best chance of generating returns, while safeguarding against losses. You don’t have to cast aside high potential returns in the name of security.
BARCLAYS EQUITY GILT STUDY – THE CALMING EFFECTS OF DIVERSIFICATION
The 2007 study highlighted the fact that assets which make up a portfolio are no longer just property, shares, fixed interest or cash. Today, private equity, commodities, infrastructure and emerging market debt make up portfolios too.
The bank’s analysts compared a multi-asset market portfolio (made up of equities from developed markets, bonds, property, private equity, commodities, infrastructure and emerging market equities and emerging market debt) consisting of equities from developed markets only.
Between 1991 and 2006 the cumulative returns between the two portfolios were much the same, but the multi-asset portfolio experienced far less volatility.
Returns showed a steady rise throughout the dotcom boom in the run-up to 2000, while equities enjoyed a sharp spike. Shares fell steeply between 2000 and 2003 after the bubble burst, while returns from the multi-asset portfolio were relatively flat.
Over the same 15-year period, the multi-asset portfolio enjoyed higher annualised returns (9.8 per cent compared to 9.4 per cent for developed equities), and a lower worst month (-6.2 per cent compared to -13.3 per cent).
Tim Bond, the author of the study, says: “Moving into diversified portfolios steadily improves the key measures: volatility is reduced, the risk/return trade-off improved and the worst monthly performance, while still large, is also reduced.”