Honeymoon for DGF performance could come to an end, experts warn

DGFs have proved to be a popular investment choice in the past few years, with consultancy Cambridge Associates' 2015 report putting DGF assets under management at more than £150bn as of March 2015, up from £100bn in December 2013, as long-term investors were seeking growth and low volatility.

The report said the median DGF manager has outpaced Libor and inflation, but performance has lagged a simple 60/40 stock/bond benchmark over the past five years, although "significant dispersion" exists across returns.

A new report by consultancy Willis Towers Watson 'Diversified growth fund investing: Is there a better way?' said the high returns generated by DGFs since 2008 were generated by beta arising from favourable market conditions, namely “strong equity and bond markets in a low volatility environment”, with managers’ tactical asset allocations detracting from returns.

This echoes views expressed in Pensions Expert's recent DC Investment Quarterly. DGFs are used in 22 per cent of default funds according to the Pensions and Lifetime Savings Association, but experts say many DGFs that are aimed at the defined contribution market have large equity allocations which will fall prey to a drop in markets.

Nico Aspinall, head of UK DC investment consulting at Willis Towers Watson, said: “Our research showed that many DGFs don’t deliver the returns that the high fees suggest they should.”

He added: “We do think there are some quality DGFs out there, but our process to assess DGF quality incorporates a value creation that many simply… do not pass. By focussing on quality and value overall DC schemes can and do make allocations to high-quality DGFs at a number of different levels of investment budget.”

Steve Butler, chief executive of retirement adviser Punter Southall Aspire, said in large part changing DGFs for the DC market had involved simply stripping out assets such as property, which tend to be illiquid.

He said: “There’s been a number of cheaper DGFs coming out where they’ve subtracted certain asset classes to make them cheaper.”

However, he predicted many of these would have low take-up from schemes unless they formed part of a pension provider’s DC default fund. This is borne out by research, at least in the short term. A study by consultancy Spence Johnson last year showed the top five DGF providers attracted 71 per cent of the assets invested in the space overall in 2014.

However, this number is predicted to decrease and, while remaining high, is expected to drop to 57 per cent by 2019.

Growth in the DC market

More recent research from the consultancy found the size of the DC market for DGFs was £35.2bn in 2015. The same research expects it to reach £179.9bn by 2025.

Will Mayne, director at Spence Johnson, said in the past DGFs often had little in common besides return and risk targets, which they pursued in very different ways.

“When we first started looking at this, DGFs [were] a family of funds that was very loosely held together with the term and equity-like returns with lower volatility.”

Since then, with the introduction of the charge cap and decline in defined benefit schemes, DGF providers have worked to make them more suitable for the new DC environment.

“You’ll see a lot of managers launching funds that are focused on gearing them towards the DC market,” said Mayne. “The result of that is that the price point has shifted hugely. It used to be around 70 basis points, now they’re being launched at 50, 40, 30 basis points.”

He added this was expected to continue. The DB market, he said, is expected to be a “churn market”, where new mandates are awarded by schemes replacing an old provider with a new one, whereas the DC market can expect inflows of new money.