Diversified growth funds are in the spotlight after disappointing 2015 performance and concerns they've led DB schemes to miss out on good equity returns in previous years. Stephanie Baxter hears concerns about the popular universe
At a glance
- DGF universe has attracted negative attention after mediocre 2015
- Concern not all DGFs are direct equity replacements
Diversified growth funds (DGFs) have claimed to give equity-like returns with significantly less volatility by diversifying across different asset classes.
Yet a significant proportion of DGFs failed to deliver positive returns in 2015 – a very difficult year for most markets. This is a concern given managers are supposed to protect against downside risk during market turmoil.
At the same time some schemes may be experiencing regret by missing out on good equity returns in previous years by investing in DGFs. Despite rapid growth in recent years, total asset inflows slowed to a three-year low in Q4 2015.
Spence & Partners head of investment Simon Cohen says there is a slowing down of defined benefit (DB) schemes going into DGFs, which may be partly down to the fact many have already gone into these products. But it may also be because some consultants are urging cautiousness around DGFs.
Willis Towers Watson senior investment consultant Sara Rejal says while her firm recommends DGFs to defined contribution funds, it has few DB clients in them and "they are thinking about whether they need a DGF at all".
"It's probably understandable for smaller DB funds that don't have the governance but some big schemes are in DGFs and don't need to be."
She believes there is not enough risk management or innovation among providers, and a very high allocation to beta and credit.
"Because markets were doing so well in both equity and credit, a lot of these funds have been doing really well so there was little need or want by clients to make changes. Now that markets are more turbulent and falling drastically in matters of weeks people are starting to listen a lot more."
Spence & Partners is advising DB schemes to review strategies that contain allocation to DGFs and to be careful when investing in them. Although they are less volatile and have somewhat protected schemes against the fall in equities at various points in time, "schemes need equity".
Cohen is concerned schemes that moved into DGFs years ago have been missing out on some of the good equity returns. Although markets had a rocky second half of 2015 and volatile start to 2016, they did well in the years before that.
"DGFs aren't a direct equity replacement and shouldn't be treated as such – and, of late, their performance has been particularly disappointing too," he says.
"Since June 2011, overseas equities have grown by nearly 50%, almost managing to track the 65% increase in UK gilt prices that is used as a benchmark for pension liabilities. The 25% return on the average DGF falls massively short of what schemes needed to protect their funding position."
He is concerned where DGFs have replaced equities on the understanding schemes would still get equity returns in the long run.
"They haven't given anywhere near enough upside, and schemes don't get the returns they thought they would get. It is fine if they want to reduce risk and know they will get a lower equity return, they just need to be clear."
Cohen is concerned with how they are used in practice:
"I'm not anti DGFs, but they need to be used in the right fashion and schemes need to know what they're letting themselves in for. If they're doing asset liability modelling and assume they will get equity return with lower risk, that modelling will put people significantly into DGFs and replacing equity. Whereas there's potentially a role for both in the portfolio."
Actuary funding assumptions should take into account there will be equity-like but lower returns from DGFs, according to Punter Southall head of manager research Katherine Lynas. She points out the benefits from having protection against downside.
"You hope as equities fall you won't get all of the downside – therefore the compounding of more positive returns on the downside will give a more positive return but over a very long period of time."
Standard Life Investments investment director Malcolm Jones says his firm's enhanced diversification growth fund follows the original core design expectation for DGFs to attain an equity level of return over the cycle but with two-thirds of the volatility.
"It's true to say [DGFs] have not kept up with equities over their period of use by DB pension plans," he says. "However, in terms of risk reduction (and many DB pension plans chose to replace equities with DGFs as part of an overall de-risking design) they have generally done a good job."
Pictet Asset Management head of multi-asset Percival Stanion has pioneered DGFs but agrees there are some issues with classification.
"Our DGF is an equity substitute – we tend to run a lot of equity risk typically, although there are times when we take that out but only for relatively short periods. Some of our competitors have similar characteristics but other funds are probably less of an equity substitute and more of an absolute return fund, driven by the falling wind from bond markets.
"When government bond markets start to become a lot less friendly that will be a key test of what you've really got. If a bond fund is masquerading as a DGF then you could well find yourself exposed."
There also debate over whether DGFs give enough downside protection when markets fall.
Spence's Cohen says strategies with 50-60% allocation to equities and the rest in physical assets with no derivatives may struggle: "If they're just holding physical assets, with bonds and property going down, how do they provide protection unless they're just sat on cash? If they haven't got any protection in the form of derivatives, I can't see how they protect when markets become very correlated.
"Long-only strategies that don't use derivatives may well struggle in the low yield environment where there'll be lots of volatility and difficult to get good returns across all asset classes."
However, Lynas thinks some funds have "done really well over the past 24 months" as markets have been difficult to navigate and have "proven they know what they're doing".
"Others haven't but there'll always be managers that don't have the skill set. For the ones that have done a good job the fees are merited."
Of course there are always going to be winners and losers but as with any product DGFs should do what they promised. The next 12 months will be the real test of how they perform under pressure.
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