Can DGFs be used to boost income with low volatility?

Pete Drewienkiewicz: It is very challenging because assets held for income tend to be locked up much more than assets that are not. As a result, they are less liquid.

Even ‘liquid assets’ that deliver attractive income are less liquid, whether investment grade or high-yield debt.

You really need to put other strategies alongside a DGF

Pete Drewienkiewicz, Redington

A whole raft of explicitly illiquid strategies – direct lending, infrastructure debt – are all attractive from an income perspective but are virtually completely illiquid. They are at odds with the construction of a very liquid, asset allocation product. So I do not find the move to try and create income diversified growth funds very useful.

John Nestor: I have had to ask people to step back, look at all our asset classes and ask why we are not deriving the income they are delivering and have distribution units, as opposed to accumulation units? Because I have a plan from the employer and I have income from investments, and I want to minimise the hardcore capital that I want to liquidate. I especially really do not want to take it away from my growth engine.

We appointed two DGF managers because they could distribute income but secondly, they provided equal – and better – investment returns than two fund of hedge funds that my predecessors had put in with higher fees and a lack of transparency.

So DGFs have been a positive evolution for trustees.

Drewienkiewicz: My view is you really need to put other strategies alongside a DGF. The theme is more unconstrained investing, more outsourcing governance to someone else who is a professional.

But I think if you want income, you probably need to be a little bit flexible with your liquidity terms.

Nicola Ralston: They are all trying to generate an absolute return and some have higher income than others, but I think it is interesting there is no agreed definition of this term in the marketplace.

There are some funds that include the words ‘diversified’ and ‘growth’ in their name – though most do not – the fact is that there is no agreement and probably should not be, because otherwise you get into chasing a peer group.

William Bourne: Are you saying they should not invest in illiquids at all, or are you saying that they should not be focused on illiquids?

Ralston: You can’t invest in illiquid assets to anything other than the most minute amount if you are daily priced.

DGFs mainly invest in underlying illiquid assets through listed vehicles and that works up to a point.

However, there is a premium or discount relative to net asset value and these funds are not always as liquid as you would want them to be.

Percival Stanion: We would have illiquids only in very limited circumstances.

For instance, with property unit trusts you have to be careful about over-concentration.

There is potential for people thinking they are in a low-risk product that suddenly, because of a market discontinuity, blows up because it is a riskier than the last three years might indicate

Percival Stanion, Pictet Asset Management

In the case of assets where we can get investment trusts, we have some listed airline leases, which are the type of assets I think you are alluding to.

It is a type of asset-backed bond, which has an exposure to the real economy as well.

In most market conditions you can probably deal in small amounts of them quite well, but if you suddenly had to liquidate the whole position you would probably have to take a big haircut.

It’s a small part of the exposure and continuously monitored. You have to be very careful about the proportion you allow on those less liquid assets.

Nestor: Not wishing to be critical, but it is very difficult for trustees who do not have access to the right advisers to get that governance right and access to those markets.

DGFs are therefore an opportunity for them to get some yield enhancement with professional oversight.

Pensions Expert: Hasn’t that been the greatest misconception about DGFs – and multi-asset in general – that people think it means less governance, when actually it probably means more? There is no silver bullet; some people have bolted them on as the solution to their problems.

Ralston: The sole solution.

Pensions Expert: Whether that is defined benefit in certain areas, or defined contribution.

Nestor: I have heard finance directors say those very words.

Drewienkiewicz: Any of these types of strategy that are less constrained, are all somewhat hedge fund-like, in that they can do a huge range of things.

As traditional markets have become more squeezed and expensive, you see new funds pop up that do something very hedge fund-esque, because the traditional ways to make money from pure asset allocation are harder and harder.

As funds become more complex – they are complex, they have huge degrees of freedom – the amount of work you do up front has to be that much more significant, and it is very difficult.

Stanion: It is probably a lot harder for trustees. The environment for returns is much tougher and when we justify our objective, we do that by looking at the blended betas of what we call our strategic portfolio and then make conservation assumptions about what alpha we think we can add over the course of a cycle.

As all the betas have come down as, necessarily, they have to for bonds, it is not looking particularly attractive. You can not just ramp up the alpha to compensate or add leverage. You have to have a discussion with the client about realistic returns.

Bourne: Does that not come back to the point I made earlier: you are all, basically, using the same set of data correlations and coming up with similar answers.

Stanion: I am worried about the insidious use of risk models across areas of the investment universe that are potentially storing up huge problems, where everybody basically uses some type of value at risk model.

It becomes a type of tick-box exercise for the independent financial advice market – that they have reviewed clients and can prove they have reviewed the client’s risk tolerance and plugged them into model two, the medium-risk model, or whatever is on their matrix.

That is all being powered by, effectively, just what the last three years of performance was. So there is potential for people thinking they are in a low-risk product that suddenly, because of a market discontinuity, blows up because it is a riskier than the last three years might indicate.