How do DGFs interact with smart beta?

Andrew Soper: Smart beta is an area that trustees have picked on if you can get those exposures much cheaper than previously. Within diversified growth funds there is scope for them to use more advanced beta strategies.

Andy Cheseldine: Our experience is that smart beta is predominantly a defined benefit trustee discussion.

The cost of transition is too high, so you have to be very confident as a trustee in a defined contribution environment, that whichever active manager you are going to use is going to perform in the long term and can be moved very cheaply. I do not think that is necessarily the case with smart beta.

Soper: A lower volatility strategy has historically delivered higher returns than a straightforward equity strategy. Whether you believe that in the future it’s going to deliver higher expected returns, if it delivers lower volatility that is an incredibly important achievement for DC members and might go a long way to help alongside a DGF.

So I think certain strategies, anyway, will have an increasingly important role in DC.

Martin Dietz: A smart beta strategy is somewhere between passive and active and aims to do the same as the active managers, but at a lower cost.

With a charge cap, it is one of the tools that can then help to improve value for money.

Graham Wardle: It is so difficult to explain to members in the DC area that any more complication would not be welcome.

A smart beta strategy is somewhere between passive and active and aims to do the same as the active managers, but at a lower cost

Martin Dietz, Legal & General Investment Management

Peter Sparkes: I agree, but this is another tool in the kit to provide a sustainable pension.

Whether it is used or not will depend on the individual implementation by trustee boards and their member populations.

Pensions Expert: What kind of innovations should we expect to see in the DGF arena?

Dietz: In DB, innovation is more gradual because that is a more established market. DC is more revolutionary and drawdown is a new problem where diversification is going to help, and this is where we will see a lot of innovation.

Soper: Illiquids are tricky in a pooled fund, but while they might be appropriate for a DB scheme, it is much harder for a DC scheme. I suspect a lot of the innovation is going to be around what happens as we approach retirement, potentially around lower growth targets.

Craig Nowrie: I agree, but the two big issues are the default with the new charging cap and the new retirement freedoms and resulting income orientation.

Dietz: From an implementation point of view, a DGF can handle some illiquidity, simply because the assets are invested in so many different asset classes and if you get small flows it is not going to disturb the overall line-up.

Where it gets tricky is considering an environment where the fund faces very large drawdowns over an extended time period.

Sparkes: Surely the bottom line is that DGFs came about to reduce or control volatility and risk. If we can introduce other asset classes into DGFs but maintain that approach to reducing volatility and risk, I do not see the problem.

However, the actual implementation may be different because the mix of asset classes you would have to put together would, inextricably, then change what a DGF aims to do and take it away from its original intention.

Pensions Expert: Does that mean, though, we are not going to see the introduction of more illiquid assets until we have more mastertrust structures – like in Australia – or the consolidation forced on the industry by the Dutch regulator?

Cheseldine: I do not see that it helps, necessarily. If you only have six providers and each of them has the same sort of DGF, each of them has a similar allocation and that market falls, they all have a problem – it’s systemic. The bigger your pot of money, the easier it is to use cash flow to manage liquidity.

You can say to a member that they can have their money, but that might be inherently unfair to existing investors and new investors. How far down that line can you can go while staying in a regulatory safe harbour?

Wardle: DB schemes are worried about freedom and choice and investing in illiquid assets simply for that reason. That is going to limit the percentage that goes in, at least until the landscape becomes a bit clearer, notwithstanding the fact that illiquid investments for DB schemes should be a no-brainer.

Is it right to assume that DGFs would perform in the same way as equities, over the long term, because ultimately they are there to control volatility?

Peter Sparkes, AMNT

Pensions Expert: And how do schemes assess DGF performance?

Nowrie: We need an equity drawdown, because we have had bull markets in both equity and fixed income over the past five years.

Sparkes: Is it right to assume that DGFs would perform in the same way as equities, over the long term, because ultimately they are there to control volatility?

Nowrie: It might not be unreasonable to expect returns to approximate to equity returns over time.

Dietz: I guess most DGFs will have hit their absolute return target, but this has not been a very challenging environment.

Since 2008, equity markets have more than doubled and even if you just stayed in bonds, with a little duration, you would have done really well. Assessing performance of DGFs is hard.

Soper: In the risk-adjusted return space, you simply divide the returns by the risk. Most funds look better than equities and it would enable a fund to hold more in a DGF and achieve a higher return than with equities. So, to date, most of these funds have delivered, in that sense.

This roundtable series was chaired by freelance journalist Pádraig Floyd

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