Does the rationale for holding DGFs still hold true? Lower returns – what are the options? Quantitative Easing (QE) has brought forward future returns and has artificially inflated returns over the past five years.
If market returns are insufficient to meet those objectives then there are fundamentally only three options open to investors:
- Manager skill - Trustees could make more use of active management. Whilst perhaps uncomfortable to many investors we feel this may be an environment where managers can play a greater part in return generation.
- Illiquidity - Whilst we could consider whether this is an independent risk premium, or an extension of the equity or credit risk premium, the fact remains that investors tend to be rewarded for investing in less liquid investments.
- Leverage - One option for generating the required returns if market returns are too low is to make use of cheap borrowing that is available and lever up those returns to the desired level.
Consideration for trustees
Whilst leverage may sound like a dirty word, anyone engaging in the ‘search for yield’ is effectively going down this route but the leverage is ‘hidden’ in choice of investment rather than being explicit. This is a topic in its own right for trustees to consider.
So what are the different types of DGFs?
- Diversified Beta
- Active Asset Allocation
- Absolute Return
Some will make heavy use of derivatives, some will use external as well as in-house funds, some will aim to add significant value through stock selection and some will utilise more esoteric asset classes and sources of return.
Two distinct periods:
2006-2009 – Largest recession since 1930s - Absolute Return funds fared best.
Consideration for trustees
Managers have focused on hitting their return target at a minimum level of volatility, is this right? Or do schemes really want managers to maximise returns available at a certain level of volatility? The distinction is subtle but important.
2009-2014 – Equities 6 years into a bull market – Diversified Beta funds fared best (but did they make enough hay during the sunny times for the fallow periods ahead?)
Having analysed the returns from a number of DGFs it is clear that a large part of returns in many funds have been generated through equity returns and duration plays, predominantly bets on falling government bond yields; where are DGFs going to get their returns from now the equity bull run has ended? Less liquid, alternative investments is an option, we consider this further from a pension scheme trustee perspective in our Q3 2015 investment paper.
What are the challenges facing the DGF market?
A number of funds have closed, taking in no further investments. This is generally to preserve the investment opportunities for the fund and so is to be applauded. However, this creates different incentives for the manager of the closed fund as their focus may become more on not losing clients rather than making the ‘best’ investment return. Similar issues befell the balanced fund sector in the 1990s. Is this the real reason managers have focused more on volatility over recent times?
Managers are currently grappling with how to tackle the DC market, a growth area for DGFs. Investors should be wary of the DC charge cap watering down investment opportunities for their DB investment where managers offer a single fund for both markets.
Whilst the DGF characteristics each scheme needs will vary, we feel the following are desirable across the board if a particular fund is going to generate the desired returns in the future:
- Flexibility – We feel it will be necessary in the future to be dynamic. This is a characteristic that’s not been required over the past 5 years but feel it will be needed over the next 5.
- Wide opportunity set – Being able to invest in areas outside of the traditional equity and bond markets may be crucial in being able to deliver required levels of returns.
- Greater focus on manager skill – Given our concerns over the level of market returns, and linked with the two points above, we think this will be key.