DGFs have proved popular but trustees need to consider all angles says Jonathan Reynolds
- DGFs have proved popular and by the end of 2014 approx £124bn was invested in DGFs
- Schemes need to consider the scheme’s return objective with the amount of risk taken to achieve it
- DGFs may deliver protection from volatility but trustees need to be aware of the governance burden and costs associated with these funds
There are a wide range of multi-asset investment strategies that are often grouped under the banner of diversified growth funds (DGFs). Although the term DGF has come to encompass a disparate group of strategies and potential outcomes, I shall use it to cover all types of multi-asset strategies or funds.
DGFs have proved to be very popular with both institutional and retail investors. At the end of 2014 approximately £124bn was invested in DGFs, with over 70% of this investment coming from UK pension schemes.
It is easy to see why DGFs are so popular. When asked in a recent survey "What do you think the main objective should be for a multi-asset portfolio?", 69% of respondents – who were mainly trustees and consultants – replied: "Achieving real returns but with lower volatility than global equities". This is a seemingly attractive combination.
While not all DGFs try to replicate equity returns, there is a common theme in that diversification can allow you to replicate the returns of an asset class but with much lower levels of volatility. While this has the potential to sound like modern day alchemy, many commentators believe this is possible to achieve over an investment cycle by restricting losses in down cycles.
From a trustee perspective, therefore, DGFs seem rather attractive. In a DB context they offer lower volatility while maintaining the expected level of investment return. For DC trustees, they offer members the chance to remain invested but with greater stability of fund value.
Pros and cons of DGFs
One key aspect of DGFs is that relative performance against peers should not be the major concern. In many respects what matters is the DGF's own benchmark. It is a matter of balancing the DGFs return objective with the amount of risk taken to achieve this.
Imagine a situation where our return objective is ‘the return generated by global equities over an investment cycle'. We could achieve this by investing in a passive global equity fund or in a suitable DGF. If we wind the clock forward we see that both funds have generated the same net annual return of 7% pa, with the DGF doing so at 9% volatility and the global equities at 18% volatility.
The outcome is an identical fund value but the DGF has provided a straighter line between the two points than the global equities fund.
The question is: in which fund would you prefer to have been invested?
The reality is that the DGF has delivered lower volatility but, in all probability, it will have done so at:
1. Higher cost – investment management, adviser fees and governance
2. Greater governance burden
While the net returns from the fund are the same, there may be additional adviser and governance costs. The costs also represent a potential conflict. Trustees need to have a strong working relationship with their investment consultant to ensure they are getting bespoke advice for their scheme.
The governance burden is perhaps the single most important issue. DGFs are far from a low governance option. Firstly, trustees must be comfortable that they have the required level of knowledge and understanding to invest in such products.
Secondly, trustees must be sure that they operate an appropriate governance framework. This should focus primarily on risk and not on performance. The risk in DGFs is not so much that they fall short of their performance target but that they take too much risk trying to achieve it. Monitoring this requires a different set of skills.
In conclusion, DGFs can play an important part in a DB or DC investment portfolio. They are certainly not the only solution. There is still a place for ‘long only' investment in the traditional asset classes. While it may be seen as a cliché that every scheme is different, from a trustee perspective this is actually a good observation that feeds in to one of the core requirements of trusteeship: that you need a clear understanding of the needs of your members, your scheme and the employer.
Jonathan Reynolds is client director at Capital Cranfield Trustees
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