How has the DGF space developed?

Percival Stanion: I inherited an old-fashioned balanced business, in 2001, which had been fatally damaged by the dotcom bust. I had to quickly rebuild what we had. What struck me was we had been through an extraordinary period of super-normal returns during the 1980s and 1990s with very few negative years, very high correlation between equities and bonds and very few down markets.

And except for Japan, asset allocation had not been rewarded for a 20-year period – it did not really pay you to switch from one asset to another. Asset allocation had dropped from favour.

There haven’t been any spectacular blow‑ups but there have been some brushed under the carpet

Nicola Ralston, PiRho

So we went back to first principles and freed ourselves from the tyranny of the benchmark by describing our mandates with an absolute objective that was equity-like in its return characteristic but which had no volatility.

It compelled us to think about protection of downside, which we thought our clients actually would value. In the early noughties, there was no consultant buy-in, nor was the pension fund sector looking at it.

It was only with the development of FRS 17 and some of the smaller consultants basically looking at the problem of the asset allocation risk and whether they really wanted to do it themselves that they started looking for people like us.

As we went through the middle of the decade, we saw people who are now household names approaching the problem of trying to build a portfolio that satisfied a liability, rather than matched the benchmark, with considerable sensitivity to downside risk. Then it started to take off and now there are about 50 providers.

Competition is great, but when competition is just people producing me-too products I worry the skill set is not there across all of them, and there will be some disappointment with returns. Nobody has blown up spectacularly yet, so there has not been any sort of invalidation of this concept of managing money.

Nicola Ralston: There haven’t been any spectacular blow-ups, but there have been some brushed under the carpet. Over the years, some funds have been quietly dropped and airbrushed out of history, and we do not hear of them because they are not on Bloomberg and Thomson Reuters Datastream anymore.

While it is true they didn’t have huge assets, some funds were of reasonable size, but nobody remembers them anymore.

Pete Drewienkiewicz: In the wider global asset allocation space, there were definitely funds that had considerable assets that were down 40 to 50 per cent in 2008–2009.

It is important to remember: funds that used to bracket themselves one way have chased the successful paradigm of marketing this particular niche. They’ve realised it looks a bit like a DGF and ask marketing if they can rename it.

William Bourne: There have been examples of precisely that, of people renaming perfectly good funds as DGFs, but I think this is the marketing team taking a good concept and mislabelling it.

John Nestor: When I look at a DGF, I am looking for the skill set that understands how markets work over a long period of time. For me, the captain on the bridge is very much the person who is the chemist putting the alchemy together, in terms of the solution. If you do not have a captain who is seasoned, with a track record and can look out over many different investment cycles, it is very superficial to push these things together. Easy perhaps to design, but it is less easy to be successful to actually win mandates.

Ralston: That is a really interesting point. We frequently have managers coming to us asking what the market is looking for as they are thinking of launching a DGF. I always say that is the wrong question – you must decide the best way to manage money in an unconstrained manner, tell us so we can decide whether we think it flies or not, and whether we think they have the people and the processes to do it.

Drewienkiewicz: The world has become obsessed with solutions and other buzzwords, which are quite admirable and sensible, but the natural endgame of the solutions world is whether someone can make something you need.

Nestor: The philosophy is vitally important. Whether you have one, or in some cases, five DGFs, you have to understand what is really the philosophy that they are looking to achieve. Without that fundamental process, you are doomed to failure.

Bourne: It also depends what is in the rest of the fund, what are you diversifying away from. I like to think we are working with open, active, defined benefit schemes, and DGFs tend to be used – and this is a generalisation – as ballast, in a world where bonds are just not providing sufficient returns.

On the other hand, many would say they are diversifying away from equities to take a bit of risk off the table. I do not like that but that is how a lot of people would see it.

Drewienkiewicz: It’s cynical, but in a world where people were derisking but trustees were not widely buying liability-driven investment, the only way you could sensibly derisk was to come up with some sort of magic asset that would earn you equity-like returns but with lower volatility.

They haven’t necessarily achieved this – if people had stayed in equities but embraced LDI to solve their volatility problem, many funds would be fully funded. So DGFs have ended up being a solution to a different problem.

There might be seven major decisions over 10 years that make or break a track record, making assessment on a quantitative basis utterly pointless

Pete Drewienkiewicz, Redington

Ralston: Some have targets versus an inflation measure, which might be retail price index or, increasingly, consumer price index; some versus cash; and then there are different levels of target outperformance. Should we compare funds against each other or should we compare them against their own targets?

Stanion: You should compare them against each other. You should compare them against what their target is, you should compare them against what was available to what the underlying returns on assets were. But there is a danger with peer groups in that it can produce the kind of herding behaviour we were trying to get away from.

Drewienkiewicz: I would go further and say that even the track record of DGFs with relatively long track records has been determined by a handful of decisions. There might be seven major decisions over 10 years that make or break a track record, making assessment on a quantitative basis utterly pointless.