Pension schemes spill into DGFs to lower volatility

DGFs – which target equity-like returns at lower volatility – are gaining popularity among schemes trying to reduce volatility in their portfolios, as well as those with limited governance looking to diversify.

The size of the DGF market has grown to £117bn in 2015, from just £25bn in 2010, according to data from investment consultancy Punter Southall published last week.

Steve Butler, managing director, said DGFs started to rise in popularity following the financial crisis.

“The credit crunch was their proof of concept,” he said. “Because they use a range of assets, they didn’t see anything like the downturn of other assets.

“For a pension fund, it’s just as important to manage their risk as it is to seek return.”

The promise of downside protection and lower volatility compared with equities are an important part of DGFs’ appeal.

They achieved monthly returns of between -3 and 4 per cent over a three-year period, according to the research, compared with -7 to 7 per cent for the FTSE All-Share Index.

“You’re looking for confidence that it will perform in all market conditions,” Butler said.

However, while DGFs see less upside when compared with equities, John Finch, director of investment consulting at JLT Employee Benefits, said DGFs could match the asset class over a long enough timeframe.

“Over time you should get a similar return to equities, but with lower volatility,” he said, adding the caveat that “DGFs will underperform in strong equity environments.”

But despite the perceived benefits, Andy Cheseldine, partner at consultancy LCP, said schemes should focus on the risk management properties when selecting DGFs.

“If you use the wrong DGF in a lifestyle-type arrangement then you haven’t added any value, you’ve just added cost,” he said.

Growth of DC

Finch said the use of DGFs was growing among defined contribution schemes, with funds being developed in the 45-50 basis-point range to come under the 75bp DC charge cap.

“They’re not that far different [in price] from global equity funds,” he said.

Peter Hall, senior investment consultant at Momentum Investment Solutions and Consulting, said the push to provide lower-cost DGFs has changed the way they are approached.

“There has been a move to more liquid and passive implementation within DGF strategies to fit within the constraints imposed on DC funds,” he said.

Hall added that DGFs are typically viewed as part of the return-seeking or growth assets for defined benefit schemes, and an aspect of the accumulation phase for DC funds.

“However, with the new pension freedoms there may be a desire from DC members to retain an allocation to DGFs through retirement as part of a drawdown strategy,” he said.