How does the use of DGFs differ between DB and DC portfolios?

Nick Ridgway: From a defined benefit perspective, diversified growth funds have been used almost as an equity replacement in some cases. If schemes have derisking frameworks in place and increasingly cannot tolerate the risk of being in equities but still require a higher return, they have used DGFs to get their ‘equity-like’ return, believing that the DGF is going to deliver that over the longer term, but with less risk.

DGFs have evolved through time: the more specific return profiles have become, the more uncorrelated [to traditional markets] and the more control over the strategy a DB pension scheme trustee has had.

This trend has allowed some to keep equities on the table because they have a DGF solution that is fairly uncorrelated to equities.

Some schemes blend DGFs together to get a more optimal return profile. This is potentially where defined contribution has utilised some differentiating DGFs. Overall there are different types of DGFs used for the DB market compared with DC.

Some are more expensive and have been more illiquid, in terms of the exposures they take – which do not really lend themselves well to the DC landscape.

From a defined benefit perspective, diversified growth funds have been used almost as an equity replacement in some cases

Nick Ridgway, Buck Consultants

James Monk: The biggest significant difference between the two in my view is actually down to the operations of linking to the platform, needing the daily liquidity, needing the Ucits regulation, which obviously controls the level of illiquid assets you can have within that portfolio.

So we are starting to see DC-light versions of the full-horsepower DB strategy. But as to how they are pitched and the risks they are managing, I am not sure they differ a vast amount to be honest.

Pensions Expert: Mike, in terms of proportions of sales, where do you see most of your clients?

Mike Brooks: We are in a phase at the moment where DB is gradually declining from very, very large numbers and DC is growing from very small numbers. So the future will be DC, but there is a very large legacy DB business that is going through this derisking phase and, as Nick said, part of that is moving from equities to diversified growth, and certainly some pension funds, some consultants, will see it as a step on the path to eventually complete buyout, moving from equities to diversified growth and then along the risk spectrum. Others may maintain their diversified growth investments a lot longer.

Monk: For those sponsors that are more engaged and want more active management, they might have perhaps had 100 per cent DGF within their member journey at some point or other, which they are obviously no longer able to do unless they are subsidising the asset management fees.

So it depends on whether you are a large scheme or a small scheme, really, to what degree you are limited in your exposure to DGFs.

Kevin Frisby: One of the big trends is towards DGFs that are targeted towards the DC market and are coming in at quite a competitive price point.

Or, if the trustees prefer something which is more expensive but perhaps lower risk and more capital preservation, they are having to dilute that with increasing amounts of passive equity. So they are going in one of two directions, either going for the cheaper price point or blending with passive to try and keep themselves under that 0.75 per cent cap.

Brooks: When you talk about that cheaper price point, what do you think that actually means for the total expense ratio of the actual manager, given the other platform fees and admin fees; is that 50 basis points, is it 60bp or what? Or is it less than that?

Frisby: In terms of the annual management charges, we have seen ones in a band between 30 and 50, and then the TERs will be higher but vary depending on the manager and the platform.

Monk: Another important part to that is whether the TER is capped. So a TER cap is really useful in terms of being able to maximise your active management within the strategy, if you were looking to do that.

Jonathan Reynolds: My view on the charge cap is that if DGFs are the answer – and there is a lot of use of them at the moment – the asset managers will meet the challenge of the 75bp. If they want to play the game, those are the table stakes; you have to come to the table with something that works. And they will find a way of doing it; whether it is blending with more and more passive elements into the default strategies, I think that will happen.

On the DB side, a lot of it is consultant-led. The blending of DGFs, especially, is very consultant-led. To be honest, it is a bit of a recurring theme. If you have a portfolio of clients, like most independent trustees, you will hear the same stories; they come from different consultants; it is the same story.

And there have been a lot of moves out of passive equity – not so much passive bond, but passive equity into DGFs. And at the moment it seems to me the next phase is a sort of reassessment of the DGF, or this concept of blending.

My view on the charge cap is that if DGFs are the answer, the asset managers will meet the challenge of the 75bp

Jonathan Reynolds, Capital Cranfield

I am a little cynical at times in thinking you just need to step back from this and say, ‘Hang on a second, is this really right for us and our fund?’. Because some of the advice you get does not always seem to be particularly bespoke. It seems to be a bit, ‘Right, this is the way forward: blend these two, blend these three funds and it will give you the right risk profile.’

Ridgway: That is a very good point; on the concept of blending, you need to understand, or appreciate, what you want. Are you trying to negate significant risk in one portfolio and offset with uncorrelated exposures in another? If that works, then, great, you have a fantastic blend.

But to achieve this you need to take a step back, revisit your strategy and focus on what you are looking to achieve. And if multi-asset still is a solution for you – and you want multiple strategies – then you can look at differentiated strategies that could blend.

The concept of blending, however, is constantly a challenge, as it is very difficult to blend optimally because strategies employed are themselves changing quite a lot.

How can you have full confidence that, say, a 50/50 blend will get you the return profile you are looking for? The concept needs to be revisited in cases where underlying strategies used have not delivered in line with expectations.