An increasing number of DC schemes and consultants are expressing dissatisfaction with DGFs. Annabel Tonry explains why investors shouldn't dismiss these funds
At first glance it would appear that diversified growth funds (DGFs) have begun to disappoint both defined contribution (DC) plans and their consultants, with the cry of 'Oh, if only we had been in equities for the last five years!' becoming ever more common. And in some cases, where there has been underperformance of stated objectives, this may be a fair assessment. But with such a huge universe of DGFs, with wide-ranging investment processes and differing implementation, and such an extraordinary market cycle, is it fair to throw the baby out with the bath water and just say no to DGFs?
Although DGFs often have a similar goal of delivering consistent high single-digit returns, aiming to generate equity-like returns over the medium term with lower volatility, analysis using research conducted by Mercer demonstrates the experience for the median investor in a DGF can vary widely.
Using comprehensive net-of-fees performance figures for all 56 strategies in the Mercer International Multi-Asset - Idiosyncratic and Core GBP category, the chart below gives the minimum, maximum and percentage dispersion figures for the UK DGF universe over all significant time periods up to five years.
Using this Mercer category, the one-year performance dispersion in excess of 30 percentage points stands out, with the investor in the worst-performing DGF losing more than 10% while the investor in the best-performing DGF gained more than 20%.
Admittedly DGFs are a heterogeneous bunch of funds, ranging from active to passive approaches and with varying portfolio construction methods and asset-class exposure. Even with the commonality of broadly similar investment objectives, investors should expect to see significant variance in returns.
Given this kind of dispersion though, many investors and DC schemes may be understandably tempted to move on from DGFs. What the wide range of returns really underscores, however, is the need for DC scheme managers and trustees to carry out robust due diligence. Clearly manager selection has a crucial influence on end investor returns, so doing your homework to find the right fund for your scheme needs is important.
On a slightly more positive note, it also shows that investors should not dismiss the DGF category on-masse because of a few outliers, as some funds have done exactly what they say on the tin and more.
In fact, DGFs that deliver on what they promise are resonating with investors as much as ever. The sad truth is that the investment journey for members is only going to get more difficult and less rewarding in the coming years, ratcheting up the need for flexible multi-asset solutions that can deliver strong risk-adjusted returns.
Research by J.P. Morgan Asset Management, predicting likely market returns for major asset classes over the next 10 to 15 years, shows a clear pattern - average annualised returns to be expected from a basic balanced portfolio that invests 60% equities and 40% bonds have fallen steadily since the financial crisis, and are down to just 4.1% on a sterling basis, from 8% in 2009.
The fact is that an extended period of highly accommodative central bank policy in recent years drove asset returns far in excess of underlying economic growth. The result was asset returns being borrowed from the future, and now that future is here.
Equally, DC plans also need to be clear about why they are using a DGF in their default, where it sits in the glide path, and what they are expecting from it. If DC plans were looking for equity-like returns but with lower volatility then there are a lot of DGFs that have delivered on this. DGFs also represent a cost-effective way for DC savers to access alternatives and some of the more esoteric asset classes that can boost risk-adjusted returns, such as infrastructure, private equity and extended fixed income, while remaining in the charge cap. Given the lower return forecast, the benefits of diversification are not something to be sniffed at.
In a challenging return environment, DC savers need to be allocated to funds that have the potential to boost returns back towards the levels to which they have become accustomed. DGFs able to take a flexible approach and allocate across a broad set of asset classes to enhance beta returns through active management, while keeping a lid on costs and doing what they say on the tin, are still worth a look.
Annabel Tonry is client adviser for UK defined contribution at J.P. Morgan Asset Management
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