Many diversified growth funds under-performed during the equity bull market, so with volitility predicted to be on the way, how will the product that claims to offer higher rewards for lower risk fare?
The range of diversified growth funds (DGFs) strategies is as varied as the investment strategies they offer, from absolute return through to dynamic and strategic funds. The one thing they have in common is that they target equity-like returns with lower exposure to volatility. This appeals to pension schemes fearing the effects that tapering will have on inflated equity and bond markets.
While DGF returns have often been disappointing when compared to the performance of equities, the litmus test now is how will they perform in volatile periods like at those witnessed earlier in the year? Since the 2008 financial crisis, institutional investors have warmed to DGFs with inflows into multi-asset funds increasing six-fold between 2005 and 2015, according to Henderson Global Investors.
A PARADIGM SHIFT
Historically, defined benefit (DB) schemes have been one of the key drivers behind multi-asset growth, yet research firm Spence Johnson predicts a paradigm shift. It forecasts that defined contribution (DC) schemes are becoming one of the key drivers of DGF growth, accounting for £27bn of inflows by 2020, compared to a mere £3bn from final salary schemes.
There are two key factors behind this trend. The first is the introduction of the DC charge cap, which has caused a growing focus on fund costs among schemes. The second is the introduction of auto enrolment, which has dramatically increased the assets of DC schemes. Demand for DGFs from DC funds is going to accelerate even further with plans to lift employee contribution rates to 8% from April 2019, up from 5% today. According to one consultant, DC scheme assets will increase to £612bn in 2030 from £377bn in 2016.
Providers have responded to this shift in demand by tailoring DGF funds to the needs of the DC market by making them charge cap compliant. Examples include Blackrock’s Dynamic Allocation Fund and Fidelity’s Diversified Markets Fund.
Yet the shift to DC presents the industry with new challenges, argues Jonathan Reynolds, independent professional trustee at Capital Cranfield Pension Trustees. Rather than merely having to convince a board of trustees at a DB scheme, fund providers increasingly have to win over scheme members, he explains. “Defined contribution schemes are a different story from defined benefit schemes because they are more reliant on contributions, which require confidence. This makes the investment bit so important as DGFs can play a role in giving members that confidence.”
Alan Pickering, chair at independent trustee specialist BESTrustees, adds that in DC land the challenge is do you go with the inertia in which lot’s of members won’t check their balance sheets every year or with members are looking annually what the fund has done. If anything, scheme members will be more likely to measure a fund’s performance by how their savings have increased compared to the previous year, rather than considering how a certain fund has performed against the benchmark, he warns. “The challenge is to encourage members to hang on for the long term, rather than becoming traders.”
Indeed, DGFs are increasingly being challenged on whether they are able to uphold their risk and return offering. One key criticism is that solid DGF returns since 2008 were largely driven by equity and credit beta, while tactical management decisions were more likely to detract value, as a 2016 report by Willis Towers Watson found.
In other words, DGFs were riding the wave of overall stable equity markets with lower volatility. “The question is, how much value have managers actually added through their asset allocation strategy?” questions Paul Berriman, global head of fund business at Willis Towers Watson.
“Producing alpha in any asset class is difficult enough but doing so in DGFs is arguably even tougher given the skill required to produce alpha from both stock selection and asset allocation,” the Willis Towers Watson report stresses. Indeed, as global equity markets became more volatile from 2016 onwards, the inconsistencies in DGF performance came to the fore. As a KPMG report in 2017 highlighted: “Over the last four years (Q2 2013 to Q4 2016) DGF managers have broadly failed to keep pace with equities, even on a risk-adjusted basis.”
The study also shows that divergence in DGF fund performance can be understood by considering the volatility of returns of a company’s stock against those in the broader market, otherwise known as its equity beta.
While funds with low levels of equity beta were among the best performing funds between 2006 and 2012, and funds with high equity beta tended to be the worst performers, the situation reversed in the subsequent three years, as DGF funds with high levels of equity beta became some of the best performers while low beta funds tended to underperform. Moreover, strategic and dynamic funds, which represent about 70% of the DGF market, accordind to Spence Johnson, tended to rely on equity market performance as a key factor in their overall returns, while absolute return oriented DGFs capitalised more on currency trades.
A key challenge for managers of strategic and dynamic funds was that they were relatively defensively positioned, avoiding US equity markets, which they considered to be overvalued. So subsequently they missed out on sectors which rallied strongly.
Meanwhile, the main difficulty for absolute return DGF funds appeared to be that they found themselves on the wrong side of central bank action, as many managers overestimated the pace of tapering measures, the KPMG report highlighted. Craig Moran, DGF fund manager at M&G Investments, warns that the sector’s inability to offer returns means that it might start to come under pressure. “The DGF model as it stands is going to get challenged,” he says. “People are going to start to get quite disappointed in low volatility periods. The growth part of the model is very important, but, of course, it depends on where you are in the cycle of the scheme,” he adds.
THE VOLATILITY TEST
The problems for DGF funds became particularly tangible at the beginning of this year, when equity and bond markets were faced with high levels of volatility, in other words, precisely when DGF funds should have been advantageous for investors. For example, Standard Life’s Global Absolute Return Strategies Fund has performed -3.5% in the past six months. Throughout the same period, the MSCI World performed +0.43%. Similarly, Blackrock’s Dynamic Allocation fund offered a -0.49% return in the past six months, while JP Morgan’s Diversified Growth Fund dropped to -4.01% over the same period, according to Morningstar. While not every DGF fund performed badly, for example, Fulcrum’s Diversified Growth Fund offered +3.05% in the year to date, the broad variety of strategies available means that it is complex to compare the performance of individual DGF funds against their peers.
Nevertheless, pension scheme investors acknowledge that it would be unfair to directly compare DGFs to the performance of equity markets. Ian Scott, head of investment strategy for the Pension Protection Fund, believes that the real test for DGFs could yet lie ahead. “We’ve been in a peculiar period and it is very difficult to assess how these funds will fare,” he adds.
Reynolds takes a similar view. “If there is one thing we learnt from the financial crisis it is that diversity is your friend when things go wrong,” he says. “The day of the DGF is perhaps yet to come when markets trip up, that is when you can really see if they do what they say.”
A key challenge for DGF fund managers will be how to respond to the increasingly short-term nature of bouts of volatility without turning into traders. Reynolds says that trustees, particularly those of smaller schemes, are often reliant on consultants when making the decision on whether a DGF fund is worth investing in or not.
Moran argues that increased market movements could still offer opportunities. “In 2015, tactical asset allocations didn’t matter much, in 2016 volatility picked up and they became much more important to be tactical, especially given the movements in bond markets. In 2017 again the tactical element didn’t matter much because you didn’t have the opportunity but this year volatility picked up and offered a lot more opportunities. From a buyer’s perspective, it is, of course, difficult to identify whether a manager has the necessary skill to add value in a meaningful way, if you’re just adjusting 1% to 2% in your portfolio it is not really meaningful,” he says.
Reynolds remains cautious of tactical trades. “It depends on where you draw the line between strategy and tactics, what I don’t like to see is significant movement, which is, of course, hard for fund managers because that is a key element of their job. What I don’t want over the longer term is paying for stuff where we have to toss a coin whether it adds value or not. “I am very dubious of anyone who tells me that they can tactically manage a fund, especially if those tactical shifts cost me a lot of money,” he adds.
Another issue with responding to short-term volatility is that it requires relatively high levels of liquidity which in turn restricts fund managers to traditional asset classes such as bonds and equities, while precluding investments into higher returning less liquid investments. But Berriman questions whether DB funds in particular need daily liquidity. “A lot of small and medium-sized schemes think that they are getting great levels of diversification,” he adds. “What they actually get is exposure to equities and credit, with a risk that the performance of both asset classes correlates.” On the other hand, the growing shift towards inflows from DC schemes suggests that liquidity will remain a key concern for DGF fund managers, as access to a DC platform requires daily pricing.
Going forward, the challenge in responding to growing volatility will have to be addressed simultaneously with a changing investor structure, as more inflows into DGFs will come from DC schemes with a variety of risk/return requirements. A 2017 report by Aon argued that this challenge could also represent an opportunity. Compared to DB schemes, which invested in DGFs at the end of their cycle, for DC schemes more growth-oriented funds could play a vital role. Because of the variety of strategies on offer, DGFs might be able to flexibly address DC members changing risk and return requirements.