Plymouth & South West Co-op introduces illiquids and cuts DGFs

DGFs rose in popularity following the financial crisis in 2008, with many promising downside protection and equity-like returns.

The total assets under management of DGFs reached $211bn (£148.6bn) by Q2 2016, up from $186bn at the end of 2015, and $152bn at the end of 2014, according to Spence Johnson analysis.

The key test for me is how DGFs are going to perform going forwards, in an environment where equities might not actually do that well

Simon Cohen, Spence & Partners

However, in recent years some have not performed as well as investors had hoped, partly due to equities having done very well.

Trustees of the £109.2m Plymouth & South West Co-operative Society Limited Employees’ Superannuation Fund, a Co-op scheme, have “agreed to develop investment beliefs and review the funds’ growth portfolios, with a view to revisiting the rationale for the use of diversified growth funds and seek further efficiencies in governance requirements”.

This led to a decision to “reduce the fund’s holding in the existing DGF mandates”, according to the scheme’s latest report and accounts. The changes were due to be carried out during 2017 and 2018.

Schemes dip into illiquids

The trustees have also agreed to increase the allocation to passive equities by 4 percentage points, and to introduce a 10 per cent allocation to illiquid credit.

Similarly, the Somerfield Pension Scheme, another Co-op scheme, said in its latest annual report that it has agreed to introduce a 10 per cent allocation to illiquid credit by terminating its existing absolute return mandates.

Illiquid credit has become popular among pension funds as banks have had to cut back on lending to small and medium-sized businesses, creating an opening for institutional investors.

Source: Plymouth & South West Co-operative Society Limited Employees’ Superannuation Fund/Mercer

Simon Cohen, head of investment consulting at Spence & Partners, said that when investing in an illiquid asset class, “you’re picking up a premium for having your assets locked away for a fair while”.

Pension schemes can potentially “get really good returns for it because these enterprises needed capital and couldn’t access it through the traditional route of the banks”, he noted, adding that cash flow from the investments is reasonably steady.

“The downside is that you are locking away your capital if you’re a very mature pension fund… you are going to be restricted to what you can access in your portfolio so you need to be careful around that in terms of cash flow management,” Cohen cautioned.

Diversifying away from DGFs

DGF performance has to be seen against the backdrop of a very strong equity market over the last few years, apart from the more recent performance, “so you wouldn’t expect them to do that well, but I think people have been disappointed with the performance of diversified growth funds", said Cohen.

“The key test for me is how they’re going to perform going forwards, in an environment where equities might not actually do that well,” he added.

Trustees have been encouraged to seek extra sources of protection and diversified return, noted Alan Pickering, chairman of Bestrustees.

“The sad thing is that they’ve been doing that at a time when quantitative easing has meant that almost any mix of traditional bonds and equities would have outperformed most multi-asset funds,” he said.

"This means many trustees are wondering whether diversity is all it’s cracked up to be, and if so, how to gain access to diversity.”

Premium or penalty?

One option is to choose a multi-asset diversified fund. The advantage of this is “that you can hopefully pick a fund where the diversification strikes a positive chord with you in the context of your objectives, and… it’s relatively low governance”, Pickering said.

Alternatively, he said trustees can try and pick individual asset class-based funds that target particular sectors of the market.

This means “you can hone in very directly on what you want. The disadvantage is that what you want might change, and the mix might alter”.

For those who “have decided to go for a more narrowly asset class-focused alternative… illiquid credit is one which is quite attractive to many trustees in a lower for longer environment”.

Pickering added: “The challenge is to make sure that it as easy to get out of the fund when you want to get out of the fund as it is when you want to get into it, because the circumstances of the scheme might change, and the illiquidity premium might – for no fault of anybody – be converted into an illiquidity penalty.”