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 how diversified growth funds can work in line with the defined contribution charge cap, in the third of a four-part panel discussion.
Bruce White: DGFs can definitely still be a default. What you have been seeing people do is launch lower-cost versions of their fund. You have also seen more blending. One thing to be aware of is that it is easy to create a low-cost version of your fund if futures are used to get equity exposure that would otherwise be invested in a fund.
But this synthetic exposure can underperform physical investments. Low cost is generally a good thing – however, you should be aware of how people are achieving that low cost and what is included, for example the cost of exchange traded funds.
Ryan Taylor: From our perspective, we see disintegration, if you like, of the defined contribution market. We have spoken to a lot of fund managers who say, ‘Yes, do not worry. Our DGF meets the cap criteria.’ However, that is not the only charge that has to be included.
Kevin Frisby: It is not just trust and contract-based DC. You now have bundled service providers where everything is included and must not breach the 75 basis-point cap. I think you are right. The unbundled investment-only type is where I see most of the DGF market focusing. In the bundled world, if the underlying fund’s annual management charge is more than 30bp it is just not going to happen because of the other fund costs.
Taylor: The way I see it, there are two ways of getting under the charge cap. One way is to have passive equities blended with a global absolute return-type product. I do not think those absolute return type funds are going to slash their fees. They are not going to say, ‘We are going to halve our fees to accommodate the charge cap.’ They are not going to do it. It would be, therefore, in the blend. However, there is another way where you go for a growth fund which has some passive beta in it because beta is cheap.
You would have to do one or the other in order to get under the charge cap. You must make sure you are well under the charge cap because the definition could change.
Giles Payne: I have a bit of a problem with the equitised exposure to things like real estate investment trusts. Actually, you do not get the smoothing effect of those illiquid assets. Long term, you get the smoothing because they will follow the property market. However, short term you get equity-type volatility into it. You do not, therefore, actually get the diversification benefit within that fund in the short term.
White: But it is true only in the short term. The question is: what is your horizon? For most clients they are medium to long term. You do get Reits behaving more like property assets over that medium-term horizon.
Yoram Lustig: I totally agree with you that Reits, for example, have equity-like volatility over the short term. Over the long term they are more correlated with the property market. However, the problem with property is not only the liquidity and the transaction costs, it is often that the low volatility sometimes appears to be low volatility because it is based on last month’s appraisals. However, the true volatility of some of these asset classes is much higher than it appears.
There are advantages to investing in illiquids, but perhaps outside of DGFs. In an ideal world you would have a pot of illiquids, a pot of liquid growth and an income pot, and then you can play around with them and create whatever solution you want.
Allan Lindsay: You might get to a situation where things need to be communicated better. It is a naive argument to say that the lower the cost, the better you get. We have had an internal discussion recently about the fact that it is really unfortunate we are offering default DC funds that we would not put in front of our defined benefit trustees. The DB trustees are better able to protect themselves than these individual members. That just seems perverse. However, that is the regime that we have been forced down.
Frisby: Also, the timing may not be very good. If you find that, in order to get yourself compliant with the charge cap, come April 1, you are going to have to change your arrangements and load up with passive equities.
It does not feel like a good time to be going from something with low risk into pure passive equities, in terms of current market levels.
Lindsay: It seems a bit odd that it is the financially literate people who are going to be able to take themselves out of this system, leaving behind the people who need the most help. The financially literate will invest the time in looking at other options.
They can go for the higher-cost fund, which will most likely provide the better return in the longer term, or the better outcome perhaps. The ones that need the most protection will end up in the lowest-cost option, which is more likely to have the side effects that we have been talking about. Those side effects could be higher correlation to equities and higher volatility at times when they do not want it. It is all about risk and reward.
Payne: In terms of charges, you are paying for skill. Skill does cost money. However, I wonder whether, with the volume of assets under management in DC, they will be able to generate a pressure to bring fees down to a certain extent.
Recently, there has not been the competition in the market. The best performing funds have been able to continue to charge large amounts of money. However, if there is a broader range of better-performing funds, maybe there will be scope to negotiate down some fees.
