Stability through diversity?

Diversified growth funds seem to tick many of the boxes when it comes to the challenges faced by default funds. Paul Farrow finds advisers still waiting for a longer track record

Every so often fund management companies come up with a new wheeze – some simply fade away, while others stand the test of time.

Around four years ago, some people in the fund management fraternity touted diversified growth funds as the potential solution for defined contribution pension schemes. Here was a style of fund that aimed to deliver equity-like returns, but at a fraction of the volatility by using a multitude of assets including private equity, commercial property, commodities and infrastructure.

On paper the rationale for diversified growth funds sounds ideal. It was the main reason for O2 recently bringing onboard BlackRock’s DC diversified Growth fund as a default option for its members.

The phone company says it chose a diversified growth fund to replace equities as the ‘growth’ component of the fund because it has the flexibility to change asset allocation in response to market conditions, helping minimise the impact of downside risk on members.

Jo Christie, pensions manager for the O2 Pension Plan, says: “From speaking to our employees, we know that many of them want a fund that delivers steady growth over time and insulates the value of their pension against changeable market conditions. We believe a well-diversified fund, with the flexibility to actively change asset allocation in response to market conditions, is the best way to deliver this.”

With the O2 addition, BlackRock now has a dozen clients offering their members its DC Diversified Growth Fund, either as their default or as part of their overall investment offering.

Emma Douglas, head of DC sales at BlackRock, says that the idea behind diversified growth was not too dissimilar to with-profits, insomuch that they aim to smooth out returns. “We now have 15 clients out of 224 using diversified growth, yet we weren’t offering this until 2006. Big DC schemes are using it and not just as part of a line-up of funds. They are offering as a default option.”

Schroders was also an early adopter of diversified growth. Again, it says that it initially embraced the concept for the defined benefit market, but soon realised that it could prove the perfect antidote for the default option. Today, 13 per cent of its DC assets are in diversified growth.

Putting its money where its mouth is, diversified growth is the company’s own default fund for its staff members.

Stephen Bowles, head of DC at Schroders, says: “We are very pleased with the success. It is impossible to overstate the importance of the default fund. There is a chronic shortage of people wanting to save – many would rather think about where they are going to take their summer holiday than worry about their pension. They simply tick the default box and cross their fingers that passive funds will deliver. We believe diversified growth is the ideal alternative approach.”

But diversified growth providers have encountered several obstacles in getting their message across. Firstly, they have to persuade consultants and employers that this new-style fund can deliver the goods. Yet they have no track record as such to speak of, and few competitors to offer a scale of comparison.

“You have to have a market big enough for consultants to take an interest and engage – until there are funds to compare against they will not be taken seriously,” says Douglas.

Discussions with fund managers and consultants suggest that – despite the protestations of diversification advocates to the contrary – take up is slow. Persuading clients that have been used to straightforward passive equity funds for years, to radically change their thinking and to adopt strategies that embrace private equity and emerging market debt amongst other assets, is far from easy.

“They are not an easy sell,” says Simon Chinnery at JPMorgan. “There are so many moving parts. We joke about taking people around the world in a 40 minute presentation, at the end of which you sometimes just get stunned silence. There’s a lot of information to take on board.”
Jonathan Parker, funds strategy director at Zurich, says that while clients and trustees are interested in hearing about the diversified concept, the take-up has been slow.

He says: “The consulting community, clients and trustees buy into the concept rather than the strategy of balanced managed funds of years gone by. But that has not translated into a higher level of take-up because there are a number of reservations.

“Many have reservations about making it a default fund and so they are more likely to put on a range along with 80 other funds. For them, having it as a default is still a step too far.

“There is also the nervousness of people not understanding what they are buying, so there is a reluctance to invest. The nervousness centres on the repercussions if the fund does not do what it says on the tin.”

Paul Black, investment partner at Lane Clark & Peacock, agrees that the concept is attracting attention but says that many clients tell him to come back in a couple of years. He says that many clients have bigger and more immediate problems to address. For starters, many schemes have legacy DB problems to deal with – these problems for them are immediate, while the DC issue is not as time sensitive. “It is easy to put off. Budgets and costs are all issues for companies at the moment,” adds Black.

That is not to say that everybody is rejecting diversified growth. Schroders says that it has seen a greater interest from trust-based schemes, particularly those that are overlapping with DB schemes, because it reckons that the trustees are more familiar with the strategies and language that surrounds them.

“The conversations we have had have actually been very enjoyable – we can chat about concepts we understand and talk about the merits or otherwise of sterling or China, for instance. They understand that we have the flexibility,” says Bowles.

Chinnery adds: “It is a challenge with contract-based schemes because they often struggle with the basic principles. There is a lot of jargon and the financial services industry has not covered itself in glory, frequently over-promising and under-delivering.”

If it is tricky enough to persuade trustees and governance committees of the merits of diversified growth, getting members’ interest is going to be even tougher. On one level there is general communication problem of members not wanting to engage, and on another there is the issue of how much detail needs to be revealed.

Talk of emerging market debt will bamboozle your average employee – yet many do not believe that you have to go into as much detail.

“There are communication challenges, but I believe that member communication can be akin to snorkelling rather than scuba diving,” says Douglas. “Members need a broad understanding of what the fund is trying to achieve – if they want to understand the nitty-gritty they can scuba dive for more in-depth information.”

Bowles agrees that member communication for diversified growth should be more tabloid than broadsheet. The other issue is performance. The funds aim to deliver a return above a benchmark such as base rate, but this has been difficult to achieve in the short timespan the funds have been around.

Their emergence has coincided with the worst economic crisis for decades, which has left funds struggling to achieve their aim. If managers were not sufficiently diversified in the 2008 downturn (government bonds were one of the only asset classes to produce a positive return in 2008), performance will have suffered.

Parker says: “Many funds have failed to deliver. The problem is that members will not understand that the fund is down because they simply think it will deliver a positive return. They won’t care that it has beaten equities if it still means they have lost money.”
But consultants say that despite many delivering negative returns, diversified growth has begun to show its strength because they have beaten equities.
Aon Consulting says that the performance for the 12 months to 31 March revealed the advantages of diversified growth – equity markets had fallen 30 per cent whereas diversified growth had fallen by 20 per cent.

“This is still way off the target for many of these types of funds which may be cash plus 4 per cent, although they are usually based on a rolling three- to five-year period or an economic cycle,” says Helen Dowsey, consultant at Aon. “Again, the message for members can be difficult to deliver and for members to grasp. The jury is out on whether diversified growth will be able to achieve its target over five years.”

Dowsey says that performance over the second and third quarters this year has been better in absolute terms but they are, arguably, at a disadvantage when equity markets rise: a typical FTSE All Share tracker returned about 40 per cent over the last six months whereas diversified growth fund returned roughly 25 per cent.

Chinnery says: “I’m not saying we are delighted with the returns, but you can see the benefits, given horrendous events – we are there or thereabouts against our benchmark.”

Webb says: “Our recent research suggests that many of the funds in this sector did indeed provide some protection against the full horror of equity market falls, and while some funds do seem to be participating in a more positive market environment in the second half of 2009, it is still early days.”

Webb cites the four diversified growth funds on the Fidelity DC platform that have at least a 12 month track record as an example. In the year to the end of 2008 three out of four outperformed a 50/50 UK/Overseas combination, the typical default option in a DC scheme.

“This was typically done with two-thirds or less of the volatility of an equity-only portfolio, covering a period where equity markets experienced steep falls and then a rapid rise,” adds Webb, who admits it is too early to provide too much in the way of long-term performance comparisons.

The other stumbling block for diversified growth is cost – they can be a lot more expensive for members than the usual equity-based offering and especially passive investment options. 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 to pay for itself.

“This can be a mental barrier for members as it may be difficult for them to see the extra value,” says Dowsey. “There are passive versions of diversified growth designed partly to control the cost issue but one might question whether a passive diversified growth can deliver the same potential returns as these portfolios rely heavily on manager skill.”

One way of getting around the cost issue is by using diversified growth for part of the default. Fidelity said that some of its clients allocate a percentage of a default fund to a diversified strategy, rather than fully committing to it.

Black says it is an approach that he thinks can help. “You have to pay more for it [diversified growth], which is why some schemes are adopting half diversified growth and half passive equities. That is one way of getting around the cost issue.”

With diversified growth type strategies being looked at by Pada, the art of re-jigging an array of asset classes to ride out the volatility will get even more attention. Fund managers are not kidding themselves that they have found the panacea to default funds or that they can become the choice of DC arrangements any day soon. They admit that it will be a slow burn.

Performance will be a key factor. The danger is that just as members may not understand the fund falling less than a full-blown equity fund, they will not understand why the fund lags in a bull market.

Dowsey says: “We may see diversified growth becoming more popular, especially if costs reduce. However, they will need to prove that they can deliver – most of these funds have only been running for three or four years.”

Members will also need to understand the concept of volatility and that the objective is not a guarantee to beat its benchmark for them to become mainstream.

“There is still a risk with these funds that they will go down in value. It is going to be a long hard slog but we are getting noticed,” says Chinnery.