An enormous variety of strategies, risk levels and returns are encompassed under the diversified growth fund moniker. Realistic expectations and careful due diligence are essential if schemes are to pick the right one, writes JLT Employee Benefits' Jignesh Sheth.
The size and liquidity constraints of a pooled fund that needs to cater to the needs of perhaps hundreds of different clients mean that those schemes who invest their entire portfolio in DGFs may want to reconsider.
Pension schemes allocating to DGFs should be realistic about the impact on return from reducing risk
There are many approaches that fall under the DGF umbrella. Some general characteristics that they share are:
Aiming to achieve an equity-like return over the long term. Most DGFs interpret this as something like inflation + 5 per cent a year or cash + 4% per cent a year.
Targeting volatility in the region of one-half to three-quarters that of equity.
Protecting capital relative to equities during times of market stress.
How much does a DGF cost?
DGFs often charge between 0.6 per cent and 0.7 per cent a year. However, there are almost always additional costs from the underlying allocations within DGF, perhaps adding another 0.1 to 0.2 per cent a year.
On a £10m investment, this would equate to an additional £50,000 a year compared to allocating to a range of liquid asset classes through passive funds, which could be achieved at fees of around 0.2 to 0.3 per cent a year.
However, if pension schemes are to follow this more bespoke approach, they must consider the additional costs incurred from the due diligence, manager selection, transition management and ongoing monitoring of many smaller positions.
Some DGFs have achieved objectives
Recent investors in DGFs are likely to look back with some regret at not allocating instead to equities.
Certain styles of DGFs have found life particularly difficult as they have been left on the wrong side of interest rate, currency and political expectations.
Over the past 10 years though, a number of DGFs have achieved what they set out to do. In particular, they have generally outperformed, after fees, a strategy that allocated to a number of growth asset classes with systematic rebalancing. They have also protected capital relative to equities during times of stress.
Market conditions have flattered equities
The past 10 years have been extraordinary, due to both the global financial crises and the unprecedented scale of global quantitative easing.
Global equities have returned above 9 per cent a year over the ten-year period, but shy of 6 per cent a year on a pound sterling currency-hedged basis.
This is perhaps a fairer measure as DGFs serving the UK market generally consider themselves to have a pound sterling objective – the payment of UK pensions. DGF returns in our analysis, net of fees and costs, ranged from 4.5 per cent to 7.8 per cent a year. A simulated simple, passive, diversified approach achieved 4.4 per cent a year.
Equity risk was circa 14 per cent a year compared to between 5 and 9 per cent a year for DGFs.
The largest peak to trough return for currency-hedged equities was -48 per cent, compared to a range of -7 per cent to -25 per cent for DGFs. The diversified passive strategy achieved -33.7 per cent a year.
Some DGFs underperformed currency-hedged equities and some outperformed, but all had a lower level of risk. They also added value, after fees, versus the simple, passive diversified strategy.
However, for the five-year period to 31 December 2017, equities and currency-hedged equities were 16 per cent and 13 per cent annualised respectively; no DGF came close.
Set your expectations
We therefore conclude that a number of DGFs are justifying their fees. However, a DGF meeting its objectives is not always the same as a pension scheme’s expectations being met.
Pension schemes allocating to DGFs should be realistic about the impact on return from reducing risk.
They should also understand the risk and return characteristics of the DGF(s) in which they are invested.
If that does not align with their beliefs or requirements then an alternative approach or additional, standalone allocations should be considered, particularly those not used by most DGFs.
Jignesh Sheth is director and head of strategy at JLT Employee Benefits
