Trustees need to carefully evaluate whether DGFs are the right product for their investment strategies according to pensions consultants

Diversified Growth Funds (DGFs) have seen a surge in popularity in the past decade. In fact, research from J.P. Morgan found that one in six DC schemes had added a DGF to their default fund in the last year alone.

Trap

If you look at the claims made by asset managers in marketing materials, it is easy to see why. Purported benefits include high returns, strong performance and diversification. And for trustees who are seeking equity-like returns without the usual associated volatility, a DGF seems like a natural fit.

But now the tide may be turning.

Poor returns

Actuarial and consulting firm, Spence & Partners, has urged schemes to review any strategy that includes allocation to DGFs, arguing that performance has been lacklustre of late and cautioning that trustees should be wary of removing equities from investment strategies.

Simon Cohen, head of investment at Spence & Partners, explained: “Yes, [DGFs] are less volatile and have somewhat protected schemes against the fall in equity markets at various points in time, but schemes need equity. DGFs aren’t a direct equity replacement and shouldn’t be treated as such – and, of late, their performance has been particularly disappointing too.” 

He argued that trustees are missing out on the strong performance seen in recent equity markets, including an almost 50% growth in equity markets since 2011.

Spence & Partners is not the only consultancy firm to turn on the asset class. Willis Towers Watson argued in March that, while DGFs provided diversification and breadth advantages over traditional balanced portfolios, returns had been largely driven by equity and credit beta.

What this means is that the impressive growth achieved by DGFs since 2008 was mostly attributable to kind markets rather than alpha generated by asset managers. The report’s authors questioned whether most DGFs would offer the protection they were supposed to in subdued markets.

Active versus passive

Both reports highlighted that DGFs were significantly more expensive than other passive strategies. An expensive fund is not an issue if this leads to better returns but, given the poor performance experienced in multi-asset, the experts are questioning whether the costs worthwhile.

Cohen said: “The 25% return on the average DGF falls massively short of what schemes needed to protect their funding position and, to add insult to injury, schemes using DGFs are also paying higher investment charges than those using passive management for the privilege.”

In fact, Willis Towers Watson found that most traditional, liquid DGF managers had actually detracted value through their use of active management, which did not necessarily offer improved risk control. Fees charged were described as “generally not commensurate with the alpha achieved”.

What next for trustees?

Willis Towers Watson urged investors currently holding traditional, actively managed DGFs to be prepared to move their assets to more cost-effective and better structured solutions to improve the likelihood of a better investment outcome in the medium to long term.

But the report’s authors said DGFs that controlled costs by focusing on strategic asset allocation with index-tracking implementation, or using high quality smart beta strategies could still be attractive for schemes with limited resources.

For larger schemes, however, the firm said building an in-house DGF using alternative smart betas, illiquid assets, and true active management from hedge funds and private market investments would be a better option.

With markets particularly unstable ahead of a potential Brexit vote, now may not be the best time to rush out of a product that guards against volatility, but it is definitely worth reviewing your portfolio in light of this new evidence.

When considering whether a DGF may be right for your scheme, it is worth noting that not all risk is bad, particularly for a longer-term investment strategy. Most DGFs target returns at a minimum level of volatility, but a better way to look at it might be to decide on the scheme’s risk appetite, establish how much volatility you are prepared to accept and then look at ways to maximise returns.