By Atul Shinh
The popularity of diversified growth funds (DGFs) in institutional investment portfolios has soared in recent years. As investors continue to strive for relatively consistent returns through flexible investment in a range of traditional and/ or alternative return sources, there is increasing recognition that DGFs are also capable of serving the role that hedge funds have traditionally filled in portfolios. For advisers and investors, the lure of cheaper fees, greater simplicity and improved transparency can render DGFs more appetising than investing in hedge funds. However, will increasing interest in DGFs eventually result in the downfall of hedge funds?
Since the concept started in the mid 2000s, a significant amount of pension fund assets have been invested in DGF strategies, with most demand coming from UK defined benefit (DB) schemes. Mercer’s 2012 Global Manager Search Trends Report showed that for both 2011 and 2012, DGFs represented one of the most popular asset classes searched for by institutional investors in the UK. DGFs are being used in addition to or instead of hedge funds, where previously only hedge funds featured.
While the level of exposure to DGFs is still lower than to hedge funds, recently the pace of asset growth in DGFs has exceeded that of hedge funds and is set to continue. In particular, the move away from DB schemes and towards defined contribution (DC) pension provision in the UK is likely to increasingly challenge hedge funds, given the operational and liquidity requirements involved. In contrast, DC is seen as a huge growth opportunity for DGFs.
The investment case for DGFs – does it stack up when compared with hedge funds?
There are a wide variety of approaches that can be included when referring to “DGFs” and “hedge funds”, however, both can act as a diversifier for existing investor exposures. Or to put it another way, they can provide valuable exposure to new or alternative return sources. DGFs provide diversification in a simple and efficient structure which benefits investors. However, this ability is based on the use of at least a chunk of traditional beta – in particular equity and credit risk premia.
While hedge funds can be more expensive and complex, they are also capable of providing investors with exposure to a broader range of return sources than DGFs, for instance, complexity and illiquidity premia. It therefore stands to reason, that a sensible blend of hedge funds is likely to act as the more effective diversifier of returns.
For investors, this means that both approaches have pros and cons. At present, the benefits of liquidity, transparency and favourable fees mean that DGFs are in the limelight. However, hedge funds still play an important role in institutional investor portfolios, which cannot necessarily be satisfied by DGFs alone, and for this reason it is unlikely that the rise of DGFs will lead to the downfall of hedge funds.
But, to successfully compete against DGFs, particularly with the onset of DC, hedge funds will need to adapt and evolve. This may be through offering cheaper fees or light versions of existing capabilities. As both investment types continue to evolve, we may also reach a point in the not too distant future whereby labels such as “DGFs” and “hedge funds” become redundant. Instead of deciding which investment category to select, the choice for investors will be the level of sophistication they can tolerate. Will this lead to the downfall of hedge funds? No, but this perhaps signifies the decline of the label “hedge funds”.
Atul Shinh is a member of the alternatives research team at Mercer
Comments