Thursday, 21 June 2018

    Meet the man who invented DGFs

    When George Osborne outlined the pension reforms in the March 2014 Budget, the sector had to come to terms with huge changes. Laura MacPhee interviews Kevin Frisby, a partner at LCP, who claims to be the inventor of the term ‘diversified growth fund’.

    How did the DGF originate?

    The term diversified growth fund I suppose started round about 2005 or 2006 with the first wave. I came up with the term.

    I was talking to a chap called Curt Custard.

    He had been looking at the types of investments that they had in North America in the endowment fund, and some of the Canadian pension schemes. He was a fan of getting more alternatives in the investment approach, rather than the Anglo-Saxon approach, which seems to be more dominated by equities.

    He wanted to launch something that was available to the mass market, which captured some of what was going on with those larger North American schemes.

    I was doing similar work, benchmarking some big UK plans against their equivalents overseas, and trying to highlight the benefits of having a much broader spread of investments, while retaining some kind of control over the whole piece.

    So we got together and I talked to him about how his company would launch its fund, and I came up with the name.

    Then I started talking to some other managers and there was a little bit of a wave of launches at a similar time, which was around 2005-06.

    What do you consider to be the maximum size for either a defined benefit or a defined contribution scheme to capture the full benefit of a DGF?

    I don’t think there is a maximum. What we thought originally was that it was a one-stop shop for small schemes to be able to try to replicate the kind of diversity that some larger, more sophisticated schemes had been attaining before.

    That was our original thought – it would be for the small end, but we’ve seen larger schemes getting involved, and ones in excess of £1bn have been allocating to DGFs.

    Do you think there are other scheme-specific characteristics that determine whether a DGF solution is appropriate?

    There’s probably not very many limits on the downside in terms of scale of access, because a lot of them probably now are available for DC, so they can go down to quite small levels.

    There are instances where it might not serve a role

    I think there are instances where it might not serve a role. An example could be if you had a large, sophisticated scheme, which already divided up its asset classes into a whole series of alternative buckets as well as conventional asset classes and perhaps had some facility to swing the overall allocation around via some tactical overlay. A DGF would really be overlapping with what they’re already doing.

    How do you expect schemes to change their DGF allocations in the future, and is there a difference for DB schemes and DC schemes?

    There is a spectrum of DGFs in terms of risk. The first few that were put out were at the higher risk, which were more market-oriented, and pointed more towards equities and other risk assets. As pension schemes mature and as their funding improves, they’re probably likely to gravitate more towards the lower-risk DGFs, which are more focused on absolute return and preserving capital on the downside.

    In terms of DC, DGFs are increasingly being used as the default growth engine

    That would be appropriate for DB schemes which are maturing and hopefully improving in their funded status. In terms of DC, DGFs are increasingly being used as the default growth engine sometimes alongside equities as well.

    Do you see schemes using the same DGF in their DB and DC schemes?

    Sometimes they’ll start off by using a DGF in the DB, and if they have a good experience with it and  they become more confident with the manager, they might want to put that one on their DC platform because they know it and they’ve already used it. It’s a kind of statement of intent to say: “This is good enough for the DB scheme, we think it’s good enough for the DC scheme as well.” That’s assuming that it’s got all the requisite features for DC, so it normally has to be daily dealt, daily priced.

    Do you see the use of derivatives as an issue that adds to the complexity and/or risk in a DGF?

    It adds to the complexity, definitely, because lots of DGFs do use derivatives. It doesn’t add to the risk, in my opinion. If anything it reduces the risk because most of the time the managers are using derivatives either for efficient portfolio management, i.e. just getting an index exposure to something in a cheap way, which we think is fine, or they’re using it for protection.

    What’s your preference when it comes to the trade off between liquidity and the illiquidity premium?

    Most DGFs tend to just stay with liquid assets – certainly if they want their product to be available for the DC market. Rightly or wrongly the DC market seems to demand daily liquidity and daily pricing, so it’s quite rare for DGFs to have much in the illiquid area. There are some DGFs with less frequent dealings, so for example sometimes weekly or possibly monthly.

    There is an element of harvesting an illiquidity premium, but it tends to be very much at the margins because most investors seem to want something that they can sell fairly quickly. If you’re looking to access an illiquidity premium in a big way you would tend not to access that through one of the traditional DGFs. You might go through a different route. There are some funds of illiquid opportunities and that’s their main aim.

    Obviously they’ll have a different fund structure – you may have the investment drawn down over a period of time, you may have it locked up for a period of time and then just get it back. perhaps over a number of years.

    What impact will the Budget have on DGFs?

    Clearly after the Budget everything’s up in the air. The historic model has been to have equities or diversified growth, or a combination, and then gradually move into gilts and cash as you go towards retirement because you’re going to buy an annuity. Now you don’t have to buy an annuity, and therefore there’s an open question about what the default should comprise.

    That doesn’t mean that diversified growth won’t have a role. It will probably have quite a big role because there will no longer be this cliff edge when you retire.

    With the annuity liberation coming up next April, you’ve a lot more choice. You can continue to roll that over and start to draw on some income from that savings pot, rather than convert it, which means that the shape of that investment on retirement may be quite different from the classic long bonds and cash.

    How do you think DGFs should evolve over the next three to five years?

    Certainly, they should be thinking about the Budget implications and what could be DGF solution in retirement. Is there something that would be a mixture of real assets generating an income, which could be something for a retiree if they want to go into some kind of phased drawdown? That sort of DGF might have slightly different characteristics.

    Volatility is less troublesome if you’re mainly taking the income out of a product

    It might be more biased towards income generation, but it will certainly be a combination of real assets to try and maintain the purchasing power while in retirement. It would probably be liquid. It would want to be something that’s not too volatile, because I think people are concerned about volatility.

    My own view on that is that volatility is less troublesome if you’re mainly taking the income out of a product. I’m sure that the DGF managers are now sharpening their pencils and having a think about what they can do in that area.

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