Kevin Frisby from LCP, JLT Investment Consulting's Allan Lindsay, Axa IM's Yoram Lustig, HR Trustees' Giles Payne, Aon Hewitt's Ryan Taylor and Bruce White of LGIM discuss whether diversified growth funds are a good investment for schemes given the strong performance of equities, in the second of this four-part panel debate.
Allan Lindsay: Over one, three and five years, DGFs have not really done as well as equities. However, we have had a really strong equity market. You are not, and should not, be buying DGFs to get entirely equity returns or equity-following returns. In some respects you are paying a bit of an insurance premium to get that lower volatility and that greater level of certainty.
Has it really been rewarded? With hindsight, at this point, probably not. Therefore, if you are contrarian, you would probably say this is the right time to buy because something is going to happen which will reveal the market to have been mispriced.
Yoram Lustig: Over the long term, hardly anything can beat equities. It is the asset class with the highest expected returns. If you want higher returns, invest in equities; if you want higher returns, invest in emerging markets; if you want even higher returns, concentrate your portfolio in a few stocks.
However, the value proposition of DGFs is the lower volatility and downside risk achieved through diversification. In addition, you hopefully have a safe pair of hands that looks after your money.
Bruce White: DGFs are often used as the growth engine, either for the defined contribution growth phase, or with a defined benefit scheme. There is an imperative to make money as well as manage risks. One of the terms we have used is that there are risks from being ‘recklessly prudent’, in terms of a fund that takes too little risk. If the client is fully aware of that, that is fine. However, there is a risk from failing to meet long-term return objectives. That is particularly true for DC. It is also true for some DB schemes. In those schemes there is an imperative not just to control drawdowns, which is what people think of as risk, but the long-term risk as well.
Ryan Taylor: It is very rare I get the opportunity to sit down with a client and say, ‘What is the objective you want from this fund?’. It is much broader than that. However, it is then having them understand why they are in a specific fund at a specific time.
In DC we do set long-term strategies. My paths are pretty much immovable in some circumstances. You therefore have to clearly identify what each phase is meant to be doing and the types of fund that sit in that phase. You can then tinker with them a bit, within the rules and regulations. However, you predominantly have equities up front because the volatility is great. You have no money anyway, so it does not really matter and you are in it for a long time.
As soon as you have some money you start to come into the middle phase. It is then important. You start to think about your retirement and how you want to spend it and what you want to do. You therefore want to start protecting your fund. It is less about it growing, growing and growing, and more about ensuring you do not lose it.
Kevin Frisby: There has been research done over the years that shows lifestyling does not get you a better return at the end of the day in the majority of cases. Sitting in equities does. However, what it helps do is control the fluctuation in your asset values as you approach retirement.
Emma Powell: Returns on equities may be lower going forward, what will become the focus of attention?
Giles Payne: It is worth asking the question, where have the managers got a Libor-plus-four, and they neatly chug along at Libor-plus-four when other assets in the market are getting a lot more? Are they actually investing to get that return or are they leaving return out there in the market? Are they just holding on to, ‘We have hit our target; you cannot sack us for hitting the target.’
I think it is a really valid question, because they are meant to be acting in the trustees’ and the members’ best interests in achieving the appropriate return. You could argue that, for their own sake, they can just dial down the risk and still hit the return target.
Frisby: That is a really good point. So, in 2009 they should really be filling their boots and say, ‘This is a great opportunity. Spreads are a mile wide. We should be trying to go for something much more than Libor-plus-four.’
Going forward, they should be aware there will be fallow periods and Libor-plus-four will be a real stretch. They should not be saying, ‘Okay, it is February. I have made my Libor-plus-four for the year. I am done. I am out.’
Taylor: There is a chance they will not time it right and say, ‘We know the market is going to change.’ Then, all of a sudden, at the next trustee meeting they are coming to you and saying, ‘Actually we took more of a hit than we thought we would because we were not chasing, but adjusting the strategy accordingly.’
Payne: But they are claiming skill and you are paying a good lump of money for that skill.
Taylor: Yeah, but that is part of the reason you would choose that fund. You could have a Libor-plus-three, plus-four, plus-five, plus whatever you want. There is therefore a reason you chose that one in the first place. I accept what you are saying. I just think you have to give the manager a degree of latitude at the end of the day.
White: I agree with this earlier point about the need to generate above-target returns in the good years. It is unlikely they will have similarly good returns in down years, even if they have lots of skill. Unless they manage that, therefore, they do need to beat that objective in the good years. That was certainly the case in the last few years where market returns have been strong.
