Diversified growth funds are finally catching on, says Paul Farrow. But not all DFGs are equal
As many as 70 of the FTSE 100 companies now offer diversified growth funds (DGFs) as part of the fund range in their defined contribution pension schemes, it emerged last month, up from 43 last year.
The research, by Towers Watson, also shows that almost all – 92 per cent – FTSE 100 schemes now operate a default investment strategy, up around 10 per cent from last year, with the vast majority of these being lifestyle strategies that include DGFs.
It is perhaps not a surprise that trustees, consultants and employers are beginning to sit up and take notice of DGFs. Their predecessors, balanced managed funds, have struggled to deliver the goods consistently, while the economic landscape has fundamentally changed ever since Lehman Brothers collapsed.
Chris Smith, senior investment consultant at Towers Watson, says: “Getting the default investment option right has become critical for pension funds as more people are investing in them than ever before. To achieve this, many fiduciaries have segmented their memberships by individual risk profile, through a risk-assessment exercise, in order to tailor the default option, using DGFs where suitable.”
Nigel Aston at DCisions says: “It is a different world and some of the solutions that are in place are no longer suitable.”
But here we have a style of fund, whether they are called diversified growth, absolute return or target return, that aims to deliver equity-like returns, but at a fraction of the volatility by using a multitude of assets including private equity, commercial property, commodities, infrastructure and even gold.
Volatility is key with DGFs – the credit crunch and subsequent recessions, not forgetting the euro crisis, have hammered home the importance of riding the storm – members are fearful rollercoaster performance and losing money.
Andrew Benton at Barings Asset Management said that a number of DC scheme trustees now recognise that while volatility is less of an issue for their DB counterparts, for DC schemes it plays a pivotal role. “The challenge – wanting equity-like returns but with less risk – can and has been supported by multi-asset funds and diversified growth funds in the DB world. There is no reason why it can’t be successfully applied to the DC challenge.
It is a different world and some of the solutions that are in place are no longer suitable
He adds: “During the downturns of 2008-09 and summer 2011, our flexible approach to asset allocation helped support our investment objective to outperform UK inflation over the medium and long term. For example, gold was one asset we considered an effective inflation hedge and the diversification benefits that first attracted us to the commodity in 2007 largely continue today. Despite a recent sell-off in the precious metal, gold has certainly been useful from a risk reduction perspective.”
Catherine Doyle, institutional sales director and DC specialist at BNY Mellon Asset Management, says that DGFs have been used both as standalone default offerings, and as part of a blended solution, “often in conjunction with an equity strategy, and typically in the more mature stages of a lifestyling glidepath.”
Among those household name companies to have embraced diversified growth are Logica, O2 and Whitbread.
Whitbread, for instance, created its bespoke diversified growth fund for its defined contribution (DC) scheme, so it could replicate the growth component of its defined benefit (DB) portfolio. The existing £70m scheme – which offers just one investment option to members – is 75 per cent invested in the Schroders Diversified Growth with the remaining 25 per cent in passive equity mandates.
Of course, asset allocation and diversification may be words that have become more prevalent since the financial crisis but the concept has been around for centuries.
In 600AD the Babylonian Talmud proclaimed: “It is advisable for one that he shall divide his money in three parts, one of which he shall invest in real estate, one of which in business, and the third part to remain always in his hands [cash].”
In 1952 Harry Markowitz’s modern portfolio theory found that spreading exposure across different asset classes reduced volatility.
But today, the relaxing of rules has given fund managers greater choice.
It is why Evercore Pan-Asset Management tells would-be pension investors when it sells its diversified growth story that asset allocation is the main influence on returns, rather than stock selection.
“Academic research has consistently shown that getting asset allocation decisions right is the most important aspect of investment management. Over the 10 years to February 2012, an investment made into the Chinese stock market would have made a capital return of 610 per cent if held throughout the period; an investment in the US stock market would have delivered just 27 per cent,” said Bob Campion at Evercore. “Getting asset allocation right can make a big difference. Trustees cannot avoid having an asset allocation. Every day that markets trade you have to decide whether to hold shares or property or bonds or some combination of them. The future of your portfolio is largely decided by how much of each type of asset you hold.”
Measuring and comparing performance of DGF’s can be tricky as no-one DGF is the same. After all, the DGF “tag” is often attached to a wide range of funds that are managed in numerous different and contrasting ways, from hedge fund-like solutions to strategies that are more akin to “traditional” balanced funds, albeit with certain additional features.
“As such the term “DGF” is, at best, imperfect, and to compare DGFs with one another directly is both difficult and potentially somewhat misleading,” adds Doyle.
A look at figures by Morningstar shows that Schroder Diversified Growth, for instance, one of the most popular funds, has fallen 6 per cent over the past year, while it is up 4 per cent over two years and up 26 per cent over three years.
That said, the latest DCisions Ultimate Default survey showed that over three years 99 per cent of a universe of consumers they monitor would have been better off in the Standard Life DGF fund, based on a total return basis.
However, there were significant differences in value returned over shorter time spans, with one of the funds, Schroders, only giving an improved outcome to 24 per cent of people over one year – although it did far better over the longer time horizon, giving a better return to 80 per cent of people.
The term “DGF” is, at best, imperfect, and to compare DGFs with one another directly is both difficult and potentially somewhat misleading
“The findings would seem to reflect the nature of absolute return strategies, in that they claim to give good reward over a market cycle, rather than promising positive growth every single year,” adds Aston.
Aston suggests that the growth figures make interesting reading, but argues that they are not enough to judge or choose a fund sensibly. “You can’t just look at return – you have to look at volatility too.”
In the DCisions report Standard Life came up trumps again compared to other default strategies.
Complexity and communication
As DCisions shows, DFGs behave very differently. Aston remarks that the Standard Life fund is “like a hedge fund” which is trying to deliver equity returns with bond-like security. “It’s clever trick if you can do it,” he said. “It is effectively a hedge fund, investing in multiple but small positions across diversified asset classes, including currencies – it made one of its biggest gains in last September when it moved its 5 per cent holding in the Swiss Franc to the Norwegian Kroner – this is hardly the simple, ’hold and hope’ mentality that has been a fixture of defaults up to now.”
Indeed, research by investment consultancy Pi Rho found that 81 per cent of DGFs trade daily rather than weekly or monthly.
Simon Chinnery at JPMorgan notes that although many diversified growth funds measure themselves against cash, this doesn’t necessarily mean that they are low risk.
Some funds with a cash or inflation benchmark, he argues, are actually able to take considerable equity risk and offer only limited downside protection. This is particularly important in the current volatility market conditions.
“Given the different strategies available and the different risk and return profiles that exist across the diversified growth sector there is an increasing demand for transparency and simplicity,” added Chinnery. “For their part, pension plans, trustees and advisers need to be comfortable with the investment objectives of their chosen diversified growth funds, carrying out rigorous due diligence on their diversified growth managers and regularly monitoring fund holdings and derivative strategies as well as fees and charges.”
It’s a point echoed by Mike Turner, head of global strategy and asset allocation at Aberdeen Asset Management. “Buyers need to beware. DGFs’ aim of providing equity-like returns, but with significantly less variability, is gaining in popularity but their outcomes cannot be assumed from the labels alone.
“Trustees and their consultants must undertake due diligence and probably consider a combination of DGFs for their growth portfolios.”
One of the stumbling blocks for diversified growth has been cost – they can be a lot more expensive for members than the usual equity-based offering – especially passive investment options. Experts said that the cost can sometimes be as high as 1 per cent above the base charge for a DC arrangement and that means it needs to deliver outperformance of 1 per cent over rolling periods just to pay for itself.
Aston says: “Costs are coming down but they are expensive – this isn’t a problem if they perform – I’d gladly pay 0.5 basis points more if it’s worth paying for.”
It is a point that Mark Thompson, chief investment officer at HSBC Pension Scheme, made in the Clear Path Analysis report, ’Investing in Diversified Growth and Multi-Asset Funds’.
He said: “There is an assumption that all DGFs are similar and that the fees are high. What you have to understand is what the diversified growth fund is doing and how it is doing it. It’s a bit like saying a Rolls Royce is expensive and a mini is cheap. There are many different types of DGFs.”
Thompson argues that at one extreme DGFs could be all passive management beneath a static asset allocation, essentially one level up from being a passive fund.
“I would expect it to be a little more expensive than a standard passive equity fund because there will be some more exotic asset classes in there, but that would be at the cheaper end of that spectrum because you are really just buying the beta exposure of different asset classes,” he says.
“If you went to the other end of the DGF spectrum, you could say it’s almost like a hedge fund where it is all based upon the fund manager’s alpha. Like a hedge fund, the fees would be more expensive.
“DFGs are a really broad church and it is hard to put them all in one bucket. You have to understand what your DGF is doing and whether the fee structure is appropriate for that.”
One way of getting companies aware around the cost issue is by using diversified growth for part of the default. It’s why many companies allocate a percentage of a default fund to a diversified strategy, rather than fully committing to it and allocating the remainder of the portfolio to, say, passive mandates.
And while thoughts of DGF conjure images of managers actively monitoring assets, you could go one step further and go for an entirely passive DGF. That is what Evercore Pan Asset is hoping for.
In a paper it published last month it argued that its ’Growth’ and ’Balanced’ funds, with 80 per cent and 50 per cent allocations to growth assets respectively, “offer trustees attractive options either as a significant part of, or a whole, default fund”.
Campion at Evercore says: “Our proposition for DB schemes is that we can structure tailored diversified growth portfolios using index trackers for around two-thirds of the cost of leading pooled pension DGFs.
There is an assumption that all DGFs are similar and that the fees are high. What you have to understand is what the diversified growth fund is doing and how it is doing it. It’s a bit like saying a Rolls Royce is expensive and a mini is cheap, there are many different types of DGFs
“But we have also been engaging with pension consultants and DC pension funds to explore the application of our Oeic range for DC members. We think that the concept of a range of cost-effective diversified growth funds is appealing to DC members and are engaging with pension platform providers to make our funds available to GPP or Sipp schemes where there is demand.”
Aberdeen remarked in its White Paper published in April that DGFs were born out of the desire to provide long term capital growth but in a more diversified, and hopefully less volatile, manner than their predecessor balanced funds.
“Capital market volatility will remain a consideration, and asset allocations within a diversified growth structure will still need to be managed dynamically in order to limit the variability of returns over time,” says Turner. “However, there is a sound case for arguing that the returns achieved relative to the risks experienced over the last decade will continue to be more favourable for the emerging and Asian markets than the developed world for the foreseeable future. It can be strongly argued that a fund with an inherent bias to invest in Asian and emerging market regions has a potential advantage over one that does not.”
Yet Schroders has a different view and is steering clear of developing markets. Johanna Kyrklund at Schroders says that its diversified growth portfolios have been defensively positioned since August last year. It has been avoiding emerging markets, along with Europe.
“Around 10pc of our equity exposure is also protected, and our cautious strategy has been vindicated by the various European elections. And we have been reducing our exposure to gold [down to 3 per cent from 6 per cent] because it is not as effective as a hedge as it was,” she added.
DGFs look set to continue into the mainstream. But with price such an issue as auto-enrolment gets under way, pressure on charges looks set to continue.