By Cai Rees
Diversified Growth Funds are not having the best of years. Whilst equites are uniformly up, almost all of the main DGFs have lagged equity returns by around 10 to 20 % in the year to date, despite their stated aim to deliver equity-like performance with lower risk.
This is according to a representative sample of DGFs within the Lipper multi-asset universe. Meanwhile the Financial Conduct Authority (FCA) has recently confirmed that, as part of its review into asset management, it will investigate whether absolute return funds – one of the main forms of DGF – are being marketed appropriately to retail investors.
Perhaps, then, it is an opportune time to consider the role DGFs play in the UK workplace retirement market, with particular reference to defined benefit (DB) pension schemes.
DGFs come in a number of forms but are distinguished by certain common features. First, they aim to provide access to a broad range of asset classes. Second, they save trustees time by delegating asset allocation decisions within the DGF to the manger.
None of these benefits are, of course, unappealing to pension funds wrestling with a multitude of evolving challenges in the current economic environment. But a closer inspection reveals a number of limitations which may significantly detract from their value to trustees of DB schemes.
For one thing, DGFs are a very broad church indeed. Some invest only in mainstream asset classes – almost exclusively equities and bonds – with largely static asset allocation; others can be highly dynamic and employ complex long/short derivative strategies.
Although there is nothing intrinsically wrong with this, it does raise concerns about how easily trustees can understand what their schemes own, whether they have visibility over what the manager is doing at any given point in time, and what level of diversification DGFs are really providing. For instance, a DGF manager, over whom the scheme has little, if any, influence, could easily move into an asset class the trustees are elsewhere trying to avoid.
For example, a DGF could unwittingly undermine a scheme’s funding position by increasing exposure to equities at the same time as the overall scheme is attempting to de-risk by upping its weighting to bonds.
Are charges justified?
If the generic nature of DGFs is problematic, so are their fees. Typically DGFs charge 50-80 basis points, which feels expensive for an off-the-shelf fund, particularly given many of them invest in little more than bonds and passive equities. A scheme could, in theory, replicate these portfolios for lower cost, which would imply investors are paying a premium for the skill of the manager. While this is not necessarily unreasonable, trustees need to ask how much faith they are prepared to put in one manager to run or oversee a multitude of asset classes and, potentially, strategies. Does one manager realistically have the expertise across all asset classes for a total portfolio solution? Does paying a high fee for a product that is not bespoke to the needs of the scheme really make sense?
Benchmarks
If DGFs lack many of the characteristics schemes seek, why have they gained traction in the DB market? Partly, it is a function of the advice given by some consultants. While not all embrace the DGF model, some lack the resource or willingness to cover all asset classes in the requisite detail, and view DGFs as a reasonable solution.
The key problem is that the performance benchmarks of DGFs are incognisant of the liabilities and thus recovery plan of a DB scheme. As such, growth in the DGF does not necessarily correspond to an improvement in the scheme funding level. Moreover, in a de-risking context, DGFs are likely to favour asset classes such as cash, which reflects their own benchmark, but does not necessarily take account of the scheme’s liabilities.
What is an alternative?
As scrutiny of DGFs increases, with more information available about their risk-return characteristics, trustees may increasingly wonder if DGFs are too blunt a tool for a DB scheme. Some are clearly capable of hitting their own outcome objectives, but others are little more than rudimentary multi-asset portfolios, the performance and structure of which trustees could access in a more bespoke and lower cost way through alternative approaches such as Fiduciary Management.
A fiduciary manager will typically take responsibility for continuously monitoring the funding level and de-risking (or re-risking) along the scheme’s journey plan as opportunities arise within clearly defined parameters. Trustees therefore retain strategic control of the scheme but have the comfort that day-to-day investment responsibilities are being undertaken on their behalf by a partner focussed on meeting their liabilities. For those DGFs that are more expensive and less bespoke to the trustees risk and return needs, they simply cannot compete with fiduciary management when it comes to meeting the funding challenges facing DB schemes today
Cai Rees is director of EMEA & Asia Institutional Advice at SEI
