Analysis: Experts remain divided over the value offered by diversified growth funds. While DGFs offer a source of return that comes with reduced risk and daily pricing, they have come in for criticism in recent years over a perceived lack of performance and value.
A strong equity market may be partly responsible for disappointed DGF investors. According to consultancy KPMG, between 2006 and 2016, DGF managers mostly performed in line with a typical yearly objective of London interbank offered rate plus 3 per cent, but have failed to keep up with global equities.
Despite these findings, investors remain interested in the asset class. Intelligence provider Camradata said that in March 2018, global DGFs sat at the top of the most searched asset classes on its platform.
This year, and going forward, DGFs are actually quite a good place to be
Naomi L'Estrange, 2020 Trustees
Handicapped by liquidity constraints
DGFs take on a number of guises, but all seek to accommodate a range of asset classes as they look to generate returns while protecting investors from market downside.
Schemes must assess the value of certain DGFs carefully, according to Paul Berriman, who leads Willis Towers Watson’s funds business.
Investors should scrutinise the range of asset classes accessible to DGFs. “Most are actually quite constrained,” he said. “They can only invest in a few, because of [daily] liquidity.”
DGFs offer daily pricing and daily liquidity, which are used by defined contribution schemes. These do, however, limit a fund’s ability to access more illiquid assets, such as direct property and infrastructure.
“If you have daily liquidity in a fund, that’s great because you can get in and out, but it’s [also] bad, because it really, really does limit the number of strategies you can invest in,” he added.
A Willis Towers Watson report published in 2016 said that the fees charged by DGF managers are generally not commensurate with the alpha achieved.
Managers should be able to justify the fees they command for moving funds from one asset class to another, Berriman argued.
“A lot of DGFs are very narrow in their opportunity set. A lot of DGF managers find it very difficult to demonstrate they’ve added consistent value by tactical asset allocation over long periods of time,” he said.
Some schemes are taking their search for an illiquidity premium into their own hands at a cost to their own DGF exposure.
Last year, the Plymouth & South West Co-operative Society Limited Employees’ Superannuation Fund resolved to reduce its DGF allocation and introduce a new allocation to illiquid credit.
The changes were inspired by a decision to examine “the rationale for the use of diversified growth funds and seek further efficiencies in governance requirements”, according to the scheme’s latest report and accounts.
Capital preservation
Not all investors are moving away from DGFs. According to charity Barnardo’s latest annual report, the £687.9m Barnardo’s Staff Pension Scheme recently added a third DGF to its investment portfolio.
Miles Buckinghamshire, trustee executive at professional trustee company Bestrustees, said that "the trustees chose to allocate to a third DGF, as opposed to allocating to the DGFs already held, in order to access a different style of investment".
“The scheme already held two relative-value style DGFs, and so the trustees chose to appoint a multi-asset style of DGF to complement the existing holdings,” he added.
A so-called ‘traditional’ approach to DGF investment involves mostly using market exposures to obtain returns. Absolute return DGFs largely employ a relative value investment philosophy.
Alex Koriath, head of Cambridge Associates' European pensions practice, recognised that traditional DGFs have not fared well in recent years, but saw cause for optimism in absolute return funds.
“You do see some interesting [absolute return] funds that also show a more interesting upside/downside capture where there is more capital preservation in down-markets, and just a different return pattern observable in that part of the market,” he said.
Do not compare DGFs to equity markets
In January, the Financial Times reported that the US equity bull market crashed through records for tranquility. DGF returns, many of which are backed by equity growth, looked unfavourable compared to stocks.
By March, market volatility had jumped. Naomi L’Estrange, director at professional trustee company 2020 Trustees, said it is unfair to compare DGFs to equity markets, which have exhibited an “unprecedented” level of performance.
Plymouth & South West Co-op introduces illiquids and cuts DGFs
The Plymouth & South West Co-operative Society pension fund is decreasing its diversified growth fund exposure and introducing a new allocation to illiquid credit.
“The interesting thing, is that the ones that have had larger equity holdings, that have done better in the previous few years, also seem to have done very well in managing the volatility in the recent few months as well, which wasn’t what I expected,” she said.
“I think this year, and going forward, DGFs are actually quite a good place to be.”
