Have DGFs had their day?

But that does not mean that all DGFs have suffered. Although DGF managers have faced headwinds in selling to UK pension schemes, some managers have continued to find success.

While these challenges show little sign of abating, this is not the end of the road for DGFs

The popularity of DGFs burgeoned in the years following the great recession of 2007-09, as risk-averse investors trusted DGF managers to deliver smoother returns than would have been achieved through equity allocations alone.

Defined benefit pension schemes played a hugely important part in this, given their lower tolerance of volatility as they closed and de-risked. DGFs have also been popular among defined contribution schemes seeking cost effective, well-diversified and low-governance solutions.

Schemes lose patience in underperformance

However, more recently the outlook has turned negative, particularly for absolute return DGFs.

These types of fund use idiosyncratic investment techniques to target returns with low correlations to traditional asset classes, but many investors have now lost patience with their underperformance and relatively high fees. This sector of the market suffered significant redemptions over the course of 2017 and 2018.

Dynamic and strategic DGFs, which focus on allocating to traditional asset classes, have generally fared much better.

Some strategic DGFs, which use passive components and construct portfolios according to predetermined asset class weights, have delivered strong performance at a lower cost than their more active counterparts.

Dynamic DGFs, which afford the manager greater discretion to take tactical asset allocation bets, tilted in aggregate into the negative from a flow perspective, but this has still left room for some significant winners.

Source: Source: Broadridge Multi-Asset and Solutions PRISM

Besides the costs and underperformance of some of the more famous types of DGF, there have been three main reasons why the popularity of DGFs, in general, has declined.

First, as a growing number of DB schemes have approached funded status and turned cash flow negative, their focus has shifted from growth assets to income-generating assets such as fixed income.

Fiduciary management has presented an additional threat to DGFs. As the complexity of pension investing has increased over recent years, DGFs became popular for schemes that wanted to outsource portfolio construction to an asset manager.

Fiduciary management has arguably taken this process one step further in offering a more ‘complete’ solution that may, for instance, also consider liability management. A similar trend has emerged in DC with the use of bundled solutions offered by providers and master trusts.

New products threaten DGF popularity

DGFs have also suffered from competition from new product types. Multi-asset credit funds, for example, often target similar return objectives to DGFs.

The introduction of packaged multi-alternatives funds, whether focusing on alternative risk premia or on providing liquid access to private markets, has allowed smaller pension funds to access alternatives without necessarily having to use a multi-asset fund.

While these challenges show little sign of abating, this is not the end of the road for DGFs. Some of the better-performing funds have continued to attract new sales. Vertical integration has also facilitated success as managers offer a DGF as a component to a broader fiduciary offering in DB, or a bundled solution in DC.

But managers have also identified new niches to target, whether that be through a focus on environmental, social and governance factors, or other investment approaches that are differentiated from the more established offerings.

Jonathan Libre is a principal in the Emea Insights team at Broadridge Financial Solutions