How are DB schemes allocating to DGFs?

Percival Stanion: It was only in about 2004 or 2005 that some of the smaller pension fund consultants started to take interest in diversified growth funds as an equity substitute, and as a product that could help small to medium-sized funds that wanted to reduce the level of volatility of their assets at a time when IFRS 17 was making the whole asset liability mismatch much more painful for schemes.

It is critical to know what the basket of options is that the manager is drawing on, and where their performance has come from in the past

Percival Stanion, Pictet Asset Management

Subsequently, there has been an explosion in the offerings. We have seen the use of DGFs proliferate not only in the small to medium-sized DB schemes, which is where it started – we have also seen it spread to the larger schemes, where it is used as a sort of low-burn tactical asset allocation product, sitting between a big equity exposure and perhaps their bond exposure, but acting as a type of tactical risk control product between them.

Neil McPherson: One of my colleagues is a trustee on a billion-plus scheme, and exactly as Percival says, they are using them as a tactical asset allocation, and they do not want to go full fiduciary because they are too big or they do not want to give away that control. The large number of DGF providers is part of the nub of the problem. It has become such a broad church, and one man’s DGF is very different to another man’s DGF.

Pensions Expert: How do trustees go about choosing a DGF?

Shuntao Li: It is very important for consultants to understand why the client needs a DGF. Is it for equity replacement, or is it more for capital preservation?

Clients that want slightly more growth replacement with a little bit of downside control tend to go for the more directional type of multi-asset fund. If people want an allocation that just sits alongside their equities for a more risk-controlled kind of purpose, they would go for more absolute return-type funds that use a lot of hedge fund-like strategies with a very low correlation to the market in general.

McPherson: But that is where the disappointment has come, and the fund managers are playing for this. Everyone has latched on to the idea of equity-like returns and low volatility, and you cannot really do the two, actually. People are not getting the equity-like returns, or have not in recent memory. They should have looked at what is under the tin.

Pensions Expert: How important is it for trustees to fully understand the different sources of return within a DGF?

Naomi L’Estrange: It is absolutely vital, particularly to understand what the strategy of the particular fund is, what it is aiming to do and how it is aiming to do it. Some of them are so immensely complex that for the average trustee, and even for the quite experienced trustee, it is pretty difficult to understand exactly what is going on inside the box. I find it quite common for schemes to have two contrasting DGFs, and I have found that to have worked relatively well in recent years.

Murray Taylor: The main role DGFs have played is as a growth-replacement-type tool. The promise of equity-like returns with lower-volatility has been an attractive tagline for trustees, and up until two or three years ago, the broad DGF asset class was doing exactly what it said on the tin. But more recently, given equity performance, people have started to step back and say, ‘Is DGF still doing what it says on the tin, is it still doing what we want it to do?’

Everyone has latched on to the idea of equity‑like returns and low volatility, and you cannot really do the two, actually

Neil McPherson, Capital Cranfield Trustees

Pensions Expert: How important do you think it is for trustees to be aware of flexibility within DGF mandates? For example, the ranges of equity exposure within a DGF mandate?

Taylor: By looking at the ranges you can at least get an idea – the range people look at most often is the allocation to equities, as typically they are looking at something that is going to sit alongside an equity, or replace an equity.

Stanion: It is critical to know what the basket of options is that the manager is drawing on, and where performance has come from in the past. So has the manager actually made full use of the ranges that were described in the past? Have they been brave enough?

Pensions Expert: How can DGFs be used to complement other strategies?

Taylor: There is no generic answer. We see DGFs as being a core part of a scheme’s growth strategy – with satellite holdings in other asset classes that DGFs potentially can’t access – sitting alongside liability-driven investments to hedge interest rate and inflation exposure. 

McPherson: Do you see it as a core part of growth or as a core part of absolute return? I question whether it should be a core part of growth, in that many schemes use it on a Libor benchmark linked to their liabilities, and you give up the upside for that.

Taylor: We would put diversified growth in the growth bucket. At the highest level, we see two buckets in terms of when you look at investment strategy, you have a matching bucket and a growth bucket and it certainly does not fit into the matching bucket.

Li: For smaller schemes in particular, the role of DGFs is for diversification, gaining that alternative exposure.

L’Estrange: Exactly, that is the key role that DGFs play. Another question I had was around the benchmarking and monitoring of DGFs when they are all so different. I have noticed DGFs that have a benchmark and a target that are different; some report against one and others the other, and they are often inconsistent. So it can give the impression that one fund is doing rather better than it really is.

Li: Did you mean that it has a stated performance objective, say Libor plus three, and then they also have an equity-like objective? Typically, we ask fund managers two questions: what is your performance target and what is your performance objective?

Objectives tend to be more vague, equity-like return, or positive return or performance better than cash, and then performance target is when we try to pin them down. Is it retail price index-plus? Is it Libor plus? Is the performance target before or after fees, and over what period is the target expected to be achieved?

McPherson: From a consultant point of view, how many different sorts of DGF styles do you compartmentalise?

Taylor: We like to look at it in a three-dimensional approach in terms of how much of the performance is reliant on beta and how much is more reliant on alpha. And obviously there is also the asset allocation dimension to it. These could perhaps then be termed as traditional diversified, absolute return and asset allocators.