Are diversified growth funds hitting the mark?

For some, DGFs are considered a panacea for investors, offering the investment nirvana of strong returns with lower volatility.

Others, however, see these products as a fad and question their relevance.

So, just how good a job have DGFs done in meeting investor expectations?

DGFs are multi-asset programmes that flexibly invest in a range of traditional and non-traditional return sources.

The concept of DGFs started in the UK following the dotcom crash in equity markets in the early 2000s. 

Chastened by this poor equity experience, and dissatisfied with the performance of traditional multi-asset balanced strategies over this period, investors started looking at alternative methods to help generate more sustained growth in returns.

In the early days investors expected DGFs to provide a packaged substitute to a broad suite of growth asset exposures.

The handful of products that had entered the DGF space by this stage duly delivered on this mandate in the years leading up to the global financial crisis.

The credit crunch

However, the events following 2008 and their subsequent impact on markets proved challenging for some DGFs, as they experienced poor returns and performed little better than equities.

In contrast, other DGFs fared better and demonstrated strong downside protection characteristics. Faced with this divergence in outcomes, the experience of the financial crisis led to a complete resetting of investor expectations for DGFs.

It was no longer enough for a DGF to just provide growth exposure and commensurate returns. Managers were also expected to place a greater focus on the realised volatility of returns and the risk that was being taken in order to generate that performance.

As a result, DGF managers were no longer judged on returns alone but also by risk-adjusted return measures – in other words, the return produced given the amount of risk taken.

Investors also used drawdown measures to judge the depth and length of the falls in value when markets dropped.

These evolving expectations were factored into both the product design of newer participants and enhancements of existing products.

In the period since the end of the financial crisis, DGFs have benefited from the extended bull market for equities, government bonds and credit, resulting in attractive outright returns for investors.

More importantly though, DGFs have also generated compelling risk-adjusted returns.

Further, in the shorter-term instances of market weakness seen over this bull market such as mid-2011, May 2013 or October 2014, DGFs have on the whole exhibited favourable drawdown properties, particularly compared with equities.

Based on these assessment criteria, it would seem a reasonable conclusion that DGFs are living up to investor expectations.

Managing expectations

The continued growth of the DGF market, having surpassed £120bn by the end of 2014, would suggest that DGFs retain the widespread support of investors – in contrast to hedge funds, for example, which have seen a number of high-profile investor withdrawals of late.

There could be a risk that DGFs become a victim of their own success and are judged by ever-heightened expectations.

For example, for some investors, a DGF exhibiting low correlations to equities may be the primary consideration for its selection. It is likely that the same investor would also expect equity-like returns, low volatility and strong drawdown protection.

It should be of no surprise that few DGFs will be able to consistently meet all of these expectations.

It is therefore vitally important that investor expectations are based on what is achievable given the approach and style of the DGF manager.  

Atul Shinh is a member of Investec's diversified growth fund team