An investor's guide to how the DGF market is developing

These funds typically aim to offer investors returns comparable with equities but with significantly lower volatility, usually half to a third of the volatility of equity markets. 

For pension schemes, irrespective of funding level or size, they can provide an excellent core holding on which to build an investment strategy and work well alongside equities for additional growth potential and bonds for matching purposes: in effect, a core component of a derisking strategy.

According to industry research and data, more than £65bn has flowed into these funds in the past seven years and predictions suggest it will increase by a further £25bn in the next three to five years: DGFs look to be an investment strategy of choice both now and in the future.

There are already enough funds and assets in this space to see it as an established ‘class’, but also one that exhibits a huge range of diversity across investment philosophies, strategies and ways to construct portfolios, albeit with most funds sharing a similar cash-plus investment target.

Understanding DGFs

While the DGF is an investment strategy that is now embedded in the UK pensions arena, it is important to understand how the various funds are structured and what sort of funds they are. 

Many schemes combine several strategies, so the blend will be essential in delivering smooth returns and providing diversification over time. We would split the market into three categories.

Dynamic asset allocation funds: These funds will be driven by active asset allocation and the manager’s ability to identify undervalued asset classes and invest in a broad range of asset classes as and when the opportunities arise. The funds are, in essence, long-only.

Capital preservation funds: These funds are more absolute return in nature and may well invest in more derivative or relative value-play strategies. They may also have certain hedge fund characteristics and be less focused on the inherent value of underlying asset classes.

Traditional or equity replacement funds: These funds tend to be driven by strategic asset allocation and a relatively high equity weighting. Instead of operating on a tactical basis, they tend to hold a strategic weighting to equities, bonds, alternatives and cash, and positions will not vary dramatically over time. 

Over the long term, the returns may well reach the same end point as the other DGFs, but the return profile is likely to demonstrate highs and lows more akin to an equity fund.

The table below shows the composite performance of nine of the leading DGF’s based on size and length of track record, with combined assets of more than £60bn, versus the MSCI UK Index. 

The broad investment objective of these funds is GBP three-month Libor plus 3 per cent net over a full market cycle and roughly half the risk of equity markets.

Source: Momentum

Interest in DGFs has come from the desire to outsource the management of market volatility, which will present both risk and opportunity. As we saw during the financial crisis, in times of stress, asset classes can become highly correlated and fail to provide the diversification benefit investors look for. 

DGFs can provide an investment solution to enable investors to smooth returns over time while managing downside risk, but still capturing a significant proportion of market upside. 

They also help manage new accounting regulations and short-term balance sheet risk. DGFs can provide a solution for the active management of risk and return as well as additional governance and due diligence.

Michael Allen is chief investment officer at Momentum Global Investment Management