Will recent equity market volatility have a positive effect on DGFs?

Kevin Frisby: I have been studying the performance of diversified growth funds over the third quarter. It is quite interesting because there has been quite a spread. UK and overseas developed equities are down about 5.5 per cent to 6 per cent and emerging markets are down significantly more; Japan is quite negative. In that context, it has been quite difficult for DGF managers to preserve capital.

The most interesting thing is that the GARS-type have scrubbed up very well. They have been flat or perhaps even better. That formula is a good one if it is implemented skilfully. So we are still quite positive on that broad approach.

But it has been quite difficult for some managers who have limited themselves in the types of weapons they have. There are a few managers who are saying, ‘Cash plus five, I cannot do it. I will not be able to achieve my target from here because everything is too expensive. And therefore, absent of a crash, I am going to fall short.’

Nick Ridgway: Some managers might actually welcome a form of market crash.

Frisby: So the bearish managers are preserving capital, sitting tight, not taking very much risk because they do not see much risk that is attractive.

That kind of manager, if they are hoarding cash, or near cash by investing in short-dated bonds – or hiding in bonds as I would describe it – they have done okay.

But managers who tried to continue to take risk, if that risk has been gravitated towards emerging markets or commodities, they have been completely clobbered by that.

So it has been really, really tricky to keep risk on the table and to grind out returns. It is quite a difficult market.

But relative value is an important part of the toolkit. It is not easy, it is not a free lunch, and that is something that clients have to pay for. If you want someone who is deploying relative value, you are not going to get that skill for 30 basis points.

It has been really, really tricky to keep risk on the table and to grind out returns. It is quite a difficult market

Kevin Frisby, LCP

Jonathan Reynolds: Has your research shown, then, that if you have a more traditional directional approach, you are down, and if you have a more absolute return approach, you might have broken even?

Frisby: Broadly speaking, the more directional ones and the ones with more equity beta, you are seeing that in the numbers, yes.

James Monk: You would also expect that, would you not, because they are long-only and they are higher-volatility funds. They do not have the leverage and the total exposure to be able to manage those risks as effectively as, say, the absolute return funds.

It is down to the strategy and you would expect GARS and Invesco to protect better in that kind of environment because they are less dependent on market beta.

I do not think there should be an enormous change from equities to DGFs right now. Pension schemes are long-term investors; they should not really be paying attention to short-term volatility. It is about the long-term story and whether the DGF is performing in line with its expectations over the long term.

Ridgway: But what you do get with a bout of volatility that we have experienced – and Japan is a good example here – is you can identify one or two managers that were quite heavily exposed to something.

Before, when most managers were trending in the same direction, that sort of exposure was hidden and returns were obtained from a number of sources, while a lot of risk was in one particular region.

With what has happened with Japan, those strategies have found it a bit more difficult to hide relative to peers given the increased dispersion in returns.

It’s been a very interesting environment to observe. And it speaks to the importance of having a dedicated research team like we have; we try and understand strategies on an individual basis and communicate the risk these strategies are running to clients, to manage expectations.

It’s saying, ‘If x did occur in the world, like a Japan sell-off, there are one or two strategies here that could actually suffer and one or two have actually suffered in these Q3 numbers.’

Mike Brooks: These stress tests, when you do see the market falling by more than 10 per cent, highlight how diversified the fund is really. Does it actually mitigate those market falls to a large degree? And I think hardly any diversified growth and even the more absolute return strategies would say they have zero beta; they probably will have some negative returns.

To the extent you do see more turbulence, that might just change the psychology at least of some pension funds that think, ‘Well, actually, I am quite glad we have the DGF, maybe we should have a bit more’

Mike Brooks, Aberdeen Asset Management

But it is really dampening that down, and so when equity markets fall 10 per cent, you are only falling 3 per cent. And that, I think, is doing what you are saying on the tin.

A lot of diversified growth funds may have more in equities and so you would expect more like a 5-6 per cent fall in a 10 per cent downmarket. So you will have the GARS-like funds maybe falling 2-3 per cent at one end, the equity ones at 5-6 per cent and the diversified funds at maybe the 3 per cent kind of mark.

To the extent you do see more turbulence, that might just change the psychology at least of some pension funds that think, ‘Well, actually, I am quite glad we have the DGF, maybe we should have a bit more.’

Frisby: Clearly nobody wants a crash, but for DGFs it might be quite handy to have one to show their worth to clients.

Ridgway: A lot of DGF managers have built up cash allocations to act as dry powder. If there is a market crash, managers could move into asset classes at more favourable prices, which will help them generate better returns as a result.

David Hosford: It is interesting that managers might actually welcome a crash. That is quite an interesting concept, just to prove their model, almost.

But I guess it does focus attention on DGFs because while equity markets have been strong, particularly when you have gone DGF as an alternative to equity, there is that sort of, ‘Maybe we should not have; maybe we should have hung on.’

And it is not just a case of managers welcoming [a crash]; I can see some trustees also thinking, if they are in a DGF that does ride out a fall well, then they can sort of pat themselves on the back and say, ‘Well, we are clever after all.’

But I would still rather not crash.