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Diversified growth fund dissatisfaction
Over the five years to 31 May 2019, global equity markets have returned almost 8% per year on average in local currency terms*. Returns were even greater for UK investors that do not hedge their currency risk. However, the day-to-day volatility of stock prices, whilst at relatively low levels historically, can and does have a material impact on asset prices and by extension, pension scheme funding levels.
It is with this backdrop that many trustees have sought to diversify their return, seeking assets away from the foibles of equity markets. A vast number of schemes have swapped some or all of their equity holdings to diversified growth funds (DGFs). A term that covers a wide range of approaches, but essentially involves gaining exposure to an array of asset classes with the aim of generating growth at lower volatility than equities.
One of the key benefits to investors relates to governance. Through a single pooled fund, trustees can gain access to a range of asset classes without the need to find, select and appoint specialist managers for each type of asset. However, this comes with a need to carefully appoint and control that individual manager risk. Over this latest long period of attractive returns from equities with relatively low volatility, many DGFs seem to have disappointed. This has left many trustees questioning their faith in the DGF approach. However, is this justified?
Have DGFs actually disappointed?
We would argue on the whole, no they haven’t.
The chart below illustrates how a number of well known DGFs have performed over the past 3 years:
Our key comments on this chart are:
- The yellow box highlights the broad range of objectives of these funds, which are usually expressed in the form of a specified outperformance above cash or inflation.
- While most of the achieved DGF returns are close to their objective returns over this period, they have significantly lagged equity markets.
- The chart does highlight some DGFs have disappointed relative to their objective, some quite substantially. This illustrates the manager skill risk that is inherent in these funds and highlights the importance of good governance around fund selection and monitoring processes.
- DGF objectives are intended to be broadly in line with equity market returns over the long term - for example over a full market cycle.
- Many equity markets are currently relishing in their longest bull runs in history - over 10 years. Given that a primary way in which DGFs look to add value is by protecting capital values during times of market stress, are we perhaps asking too much of these funds to keep pace with equity returns over this period?
Be mindful of the mandate you have given to your DGF Manager
Whilst DGFs provide diversification within liquid public markets, they cannot provide exposure to illiquid assets. This means that when returns are scarce across public markets, DGF returns will suffice. Diversification can only protect so much against losses when most of their investment universe is falling. The chart below shows that the 2018 calendar year was a great example of this:
It is important to take a holistic approach when constructing a growth portfolio
The investment universe is vast and constantly evolving, however we would argue there is really only four ways to make money;
A robust growth strategy has exposure across the main sources of risk and return
A DGF can provide exposure to three of the above areas and we must be mindful of this when comparing fund performance to a broader spectrum of returns.
We suggest trustees consider how well their current growth assets contribute to the above return sources as a whole.
Illiquid markets are an area that is increasingly being considered by pension schemes, given their investment time horizon is in many cases, longer than retail investors.
Attractive opportunities still exist outside public markets, however there are some practical considerations that need to be considered before investing:
- Size of potential investment - minimum investment amounts can be a significant barrier to medium and small institutions
- The trustees’ governance budget – the additional governance burden can be prohibitive for schemes
- Investment time horizon - illiquidity is undesirable if a scheme is looking to buyout in the foreseeable future.
- DGFs have struggled to keep up with equities during their long period of attractive returns for with relatively low volatility.
- Most DGFs have met their stated objectives over the long term. Those that have not should be reviewed urgently.
- An allocation to DGFs should help protect scheme assets against sharp losses during periods of market stress. This is important when legislation requires trustees to evaluate their funding position on a specified day every three years.
- It is important to take a holistic approach when constructing a growth portfolio. Where practical, trustees should seek to gain exposure across the main sources of risk and return.
- Diversification by allocating to alternative asset classes can bring risk and return benefits over the long term.
* Source FTSE (FTSE All-World total return index [7.7% p.a.])