Are DC default strategies diversified enough?

Take the simple and cheap diversification embedded in the two elements that underlie the most commonly used industry benchmarks, which we also use: global developed equites, covering over 1,600 stocks across diversified industries and geographies, and UK gilts, both nominal and inflation-linked across a wide range of investment durations.

From the beginning of 2011 to October 2018, the global developed market equities index (50 per cent hedged to sterling) delivered a return of 10 per cent a year.

The implications for risk-managed default strategies that do not look to change their approach will mean considerably lower returns in the future and/or higher uncertainty

A 50/50 combination of index-linked gilts and nominal gilts delivered a return of 6.5 per cent a year.

Furthermore, a simple balanced portfolio made up of 60 per cent equities and 40 per cent gilts delivered, prior to any costs and charges, a return of 8.8 per cent a year. Only 0.5 per cent of this additional return can be attributed to currency movements in the wake of Brexit.

This performance is remarkable when compared with the more active and diversified funds, which since the global financial crisis have been a popular choice for many default strategies. Typically, the simple approach compared with a diversified strategy has outperformed by 3 percentage points a year.

Clearly a significant component of the disappointing performance of more diversified funds may have been due to unnecessary UK equity home bias and poor alignment of risk management.

However, some will be down to the fact that too much diversification simply has not worked over this period – one in which the best returns came from large-cap US equities, the dominant component of the global developed equity index.

Case for diversification remains strong

From a return perspective, the case for diversification remains as strong as ever, and little credence should be placed in the assumption that because developed market equities have been the best performing major asset class of the recent past then they will continue to be so.

Hence, while a default strategy may have been able to benefit historically from focusing predominantly on developed market equities with no hedging, it may be less successful in the future.

However, even if we discount our ability as default managers to successfully rotate between equity markets to enhance long-term returns, we believe the need for greater diversification to improve risk management is more compelling than ever.

Investment conditions over the past three decades have meant any simple combination of developed market equities and government bonds achieved sufficient diversification alone to manage risk.

Conveniently, both asset classes delivered attractive long-term returns while being negatively correlated in the short term – that is in periods when the value of equities were going up, the value of government bonds were falling, and vice versa.

We expect the future is unlikely to mimic the past. Not only do the long-term returns for government bonds look worse than cash, but the reliability and level of protection they provide against sizeable falls in equity markets looks limited.

Schemes could face scale and flexibility problems

The implications for risk-managed default strategies that do not look to change their approach will mean considerably lower returns in the future and/or higher uncertainty. 

We believe alternative approaches for diversification are more appropriate to avoid the inevitability of disappointing members. Funds can seek higher returns without taking more risk via greater diversification across a broader range of equity and bond investments.

This includes private markets and utilising active management strategies, whether systematically implemented via so-called smart beta approaches or more traditional investment approaches.  

Some schemes will find it harder than others to achieve this. Those whose default strategy is primarily built to a limited investment budget are unlikely to have the flexibility to deliver the net returns that any reasonable test of value for money demands.

Others will face challenges of scale (both being too big and too small) and self-enforced restrictions of poorly implemented default investment delivery strategies, limiting their investment freedom.

Given the new market environment, where the past is unlikely to be a reliable guide to the future, the question is probably not whether the default is diversified enough, but whether the diversification is managed in the most effective manner to deliver the best outcome for members.

David Hutchins is portfolio manager, multi-asset solutions at AllianceBernstein