Diversified growth funds

What are diversified growth funds (DGFs)?

DGFs are funds that invest in a wide variety of asset classes in order to deliver real capital appreciation over the medium to long term.

Unlike most traditional pooled funds, the fund manager is given a task in terms of the end result, but a great deal of freedom as to how they achieve it.

There is quite a lot of variation between DGFs but typical aims are for a certain level of absolute return; or a certain level of return over inflation, or a certain level of return above cash.

Typically, the long-term aim is to produce a similar level of return to equities, but with about two-thirds of the level of volatility.

The strategies for achieving this vary widely from manager to manager; hopefully playing to the strengths of the particular manager.  Usually the returns are targeted from a range of different asset classes together with fund manager skill (tactical switches between asset classes as well as within each asset class).

Typical asset classes included are:

  • Global equities
  • Emerging market equities
  • Private equity
  • Investment grade corporate bonds
  • High yield bonds
  • Emerging market debt
  • Cash
  • Property
  • Commodities
  • Infrastructure
  • Hedge funds

Frequently equities (in their various forms) make up the majority of the funds.  We view DGFs as potential replacements for equity funds within defined benefit schemes’ strategies.

What are the advantages of DGFs?

  • The aims of a DGF are well aligned to the requirement from the growth component of a DB scheme’s strategy.
  • DGFs give access to asset classes that are not otherwise practical for smaller schemes…
  • …which gives greater diversification, and potentially a better risk / reward tradeoff.
  • Having a single manager across all asset classes potentially allows:

- a greater coherency of the overall strategy;

- faster and cheaper implementation of tactical asset allocation views;

- less time and money spent by trustees in hiring and monitoring managers.

What are the disadvantages of DGFs?

  • The expected returns might not be quite as high as for equities.  We expect some of the asset classes to have a lower return over the long-term, so there is potentially a small dilution of performance, which will need to be made up by fund manager skill (‘alpha’).
  • If trustees have not already hedged their interest rate and inflation exposures using the bond element of their strategy then the overall risk reduction can often be disappointing.  We have modeled cases where switching from a global equity fund into a DGF would have potentially achieved a 35% reduction in the volatility of that part of our client’s investments, but left the overall level of risk almost unchanged due to the other major financial risks of the pension scheme.
  • Under some designs of DGFs, all of the assets are managed by the same fund management house.  It is unlikely that they will be strong across all asset classes all of the time.  However, increasingly fund managers are outsourcing parts of their DGF to other firms in the areas where they acknowledge a weakness.

Are DGFs just rehashed balanced funds?

We do not believe that to be the case.

Once upon a time defined benefit schemes were truly long-term investors.  Valuations were undertaken every three years, but fluctuations in the funding level of a scheme were both expected and accepted.  The main thing was the long-term goal of making sure that when benefits eventually needed to be paid, there would be enough money available to do so.

In that happy era, a case could be made for balanced funds run against peer-group benchmarks.  Although they were not ideal in every respect, they offered heavily-equity-biased investments in a relatively-cheap bundled package.  For smaller schemes, a cheap and simple solution that was broadly right was often the best solution.

Rightly or wrongly circumstances have changed.  In order to protect the cases where employers fail leaving underfunded schemes and members with serious poverty to face in retirement, there has been greater and greater focus on short-term valuations.  First there was the Minimum Funding Requirement; then the FRS17 and IAS19 accounting standards; followed by The Pensions Regulator and the need for deficit recovery plans.

This means that trustees now need to be mindful of the short-term as well as the long-term.  In this environment it is essential for trustees to have a scheme-specific asset allocation that takes into account their liability profile, and more importantly, their investment objectives.  The most critical aspect of the investment objectives is the appetite for risk i.e. how do they get the balance between avoiding short-term risks with seeking long-term investment returns.

One size no longer fits all.  Balanced funds with peer-group benchmarks were forcefully criticised by Paul Myners in his eponymous report.  (In our view the criticism was completely justified.)

However, this may have been a case of the “baby getting thrown out with the bath water”.  Some aspects of balanced funds were sensible.  We believe that having a single manager run a fund covering many asset classes can be sensible, particularly for smaller schemes; it can keep costs down, make hiring and firing cheaper, and allow tactical decisions to be easily made across asset classes.

The aspect that was not sensible was for the critical asset allocation decision to be left to managers all just trying to beat one another.  There was no link to objectives or liabilities (not even a typical pension scheme’s requirements).

So what’s different about DGFs?

  • A DGF can be used for the growth part of a scheme’s strategy.  So if the hedging assets hedge the liabilities of the scheme, and the trustees’ appetite for risk is reflected in the percentage of the assets that are allocated to DGF, the overall strategy can reflect the needs, objectives and liabilities of a pension scheme.
  • The objectives of a DGF will be clear and in reference to a meaningful measure rather than a self-referential peer-group benchmark which forced managers to pay almost as much attention to what each other were doing as what was happening in the markets.  If your hedging assets have removed your exposure to interest rates and inflation then if your DGF outperforms cash, your funding position should improve.  If your DGF underperforms then your funding position should deteriorate.  So the aim of the fund manager would have been well aligned to the requirements for the scheme.  (Mortality and other non-investment risks will also have a significant influence on the funding position.)    Whether a balanced fund manager had outperformed his or her peers wouldn’t have given you a clue as to what was happening to your funding position.
  • DGFs invest in a wider range of investments than the old style balanced funds.  We think that this is a positive attribute.  See our section on growth assets.

Conclusion

We believe that despite the claims of DGF managers, there may be a reduction in long-term returns from investing in some DGFs compared to pure equity funds because of the dilution from the non-equity assets.  We also believe that the risk reducing benefits can often be undermined at a scheme level due to the other unhedged risks.

However, on balance we believe that they are a good combination with pooled LDI funds for smaller pension schemes to allow a tailored, cost-effective solution to be created using standardised building blocks.