It’s an odd quirk of human nature: we can find it difficult to moderate our appetites and slip into overindulgence. That appears to be happening with the multi-asset strategies that are known as diversified growth funds.
There’s been a plethora of new DGFs opening as assets flood in from both defined benefit and defined contribution pension schemes.
Nils Johnson, director of Spence Johnson, says: “The DGF industry in the UK is already substantial with around £66bn in assets under management, with an additional £30bn expected to flow into these funds by 2018.”
The growing interest in DGFs has been driven by a confluence of factors.
Two equity bear markets within a decade caused DB funds to question whether shares can deliver the growth needed to close their funding gaps. In addition, finance directors were concerned by the impact market falls had on the balance sheet.
Diversifying funds across multiple asset classes while managing the downside risk is an appealing solution for both trustees and finance directors. DC schemes’ interest, on the other hand, is borne out of a basic conservatism. DC scheme members hate losses so it is worth giving up some potential returns to keep a lid on volatility.
Whenever a trend is too attractive to resist, it’s always a good idea to take a step back and take an objective view. And there are many aspects of DGFs that should be carefully considered. Diversified growth funds are very different beasts to more standard fund products.
Johnson says: “They sit between two other multi-asset strategies – balanced funds and hedge funds.” Most of them have an unconstrained mandate so they are not trying to beat a specific benchmark. Instead they aim to beat either cash or inflation.
It’s not completely clear when these funds will achieve their target
Ryan Taylor, senior DC investment consultant at Aon Hewitt, says: “It’s not completely clear when these funds will achieve their targets. They aim to achieve their target over a market cycle while minimising the downside risk. But it’s difficult to know in advance how long a market cycle will last.”
Despite having similar targets, the strategies used by this type of fund are far from homogeneous and include strategic DGFs, dynamic DGFs, absolute return funds, target return funds and target absolute funds. Each has a different investment philosophy and can include a very broad range of financial assets.
Some make heavy use of derivatives and some will invest in illiquid assets. Others are completely unconstrained while some keep asset allocation within specific proportions. Taylor says: “They’re very difficult to compare. They are simply too heterogeneous.
“How do you assess the quality of a fund that is targeting Retail Prices Index plus 3% versus a fund that targets RPI plus 4%? The only answer is to assess each fund individually, and that takes a lot of work.”
That reliance on the right manager is considered by some to be the weakest link
Assessing which fund is right for a particular pension fund might be easier if it were possible to look back at historic performance. But this is a young investment class: the oldest funds have only existed for five to six years. Laith Khalaf, head of corporate research at Hargreaves Lansdown, says: “We’d only suggest that investors choose those funds that have been around for at least seven to 10 years. It’s particularly important in a multi-strategy to have a manager who has been through several market cycles.”
That reliance on the right manager is considered by some to be the weakest link.
The success of a DGF is reliant on the manager’s ability to get the asset allocation right through the economic cycle
Pete Drewienkiewicz, head of manager research at Redington, says: “The success of a DGF is reliant on the manager’s ability to get the asset allocation right through the economic cycle. But there are no guarantees that will happen.” A bad decision on asset allocation can have a major impact on performance.
Aymeric Poizot, head of EMEA fund and asset manager ratings at Fitch Ratings, says: “For example, a multi-asset fund that had no or limited exposure this year to emerging markets would, at the end of August, be up 4% in euro terms, while one with more emerging market exposure would be flat or even down.”
Drewienkiewicz adds: “If a pension scheme wanted to choose the best multi-asset managers then they would choose a selection of hedge fund strategies. But many pension schemes, particularly DC ones, are not prepared to pay two and 20, so DGFs are the next best option.”
The challenge ahead
While DGFs could be considered the poor man’s hedge fund, asset management firms have poured money into the way they are run. Poizot says: “The management of multi-asset strategies has changed radically. There has been a lot invested in the resources used to run these funds, including a much greater emphasis on the use of models to make the investment process much more disciplined and less emotional.”
There’s often only a small window to get it right
The challenge is to ensure that DGFs do not become bogged down by process and are still agile enough to make the right asset allocation calls. “There’s often only a small window to get it right,” says Poizot. Financial markets are also on the cusp of change that could make it much more difficult for the managers of these funds. Poizot says: “Many multi-asset funds have benefited from the recent strong performance of the fixed income markets. But it will be interesting to see if they are able to continue to perform as well when interest rates start to rise.”
We live in interesting times: markets are highly correlated because of the liquidity provided by quantitative easing
There are also challenges in the equity markets. Poizot says: “We live in interesting times: markets are highly correlated because of the liquidity provided by quantitative easing.
In June, for the first time in three years there was a positive correlation between bond and equity markets when the threat of a liquidity reduction caused both these markets to fall.” These types of market conditions make it much harder for multi-asset managers to achieve their goals, especially if the traditional relationships between different asset classes have broken down because of the impact of quantitative easing.
It’s not only the changes in market environment that could make life more challenging for DGFs: there is the very real chance that they could become victims of their own success. It becomes increasingly difficult for an alpha manager to generate good returns if the fund keeps attracting assets.
Glyn Owen, investment director at Momentum Global Investment Management, says: “How many actively managed investment products have managed to keep on growing year in, year out while maintaining good performance? Very few.” “Long-term performance is negatively correlated to the size of assets under management. Many smart fund managers close their books at a certain level because they know that it’s difficult to maintain performance,” says Owen.
My concern is that everyone is so worried about managing volatility that they have forgotten the goal of investing: to provide an adequate retirement income
Olivier Lebleu, head of non-US distribution at Old Mutual Asset Management, says: “As the church gets broader, I’m concerned that the target of returns with a low volatility that match the client’s objective is not always going to be met. I’m very sceptical that there is enough talent in the investment management industry to run well all the DGFs in the market today.”
The most important consideration, however, is to ensure that DGFs are fit for purpose. Taylor says: “My concern is that everyone is so worried about managing volatility that they have forgotten the goal of investing: to provide an adequate retirement income. It will be cold comfort to future pensioners that the ride was smooth if they have to live in penury.”