Monday, 20 November 2017

    This story is brought to you by Pensions Insight

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    Making sense of diversification in DC

    Many DC schemes have traditionally had a ‘home’ bias, with recent surveys indicating that the average default fund of a FTSE 350 firm has a 25 percent allocation to UK stocks, significantly higher than a typical global equity portfolio.¹ Catherine Doyle, Head of defined contribution, Newton Investment Management explains

     

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    UK schemes have avoided some of the worst traps which in the past have been associated with US pension plans that have a significant allocation in particular to the stock of the sponsoring company. Such exposure can prove detrimental to the employee, as times when companies experience difficulties and suffer big declines in their share price may often correlate with periods of job insecurity.

    Nevertheless, at the market level, UK market turbulence and currency fluctuations associated with the country’s decision to leave the European Union have underlined why it may be unwise for UK schemes to be concentrated in a single market, effectively putting all their eggs in one basket.

    It is our belief that market gyrations of this kind speak to the importance of having a global outlook when it comes to investing, especially for those who are saving for retirement. In our view, being concentrated in UK companies – or indeed in any single geographic area – is potentially detrimental when viewed through the prism of long-term returns.

    For example, while the UK market contains many established, well-respected companies, it is hard to escape the fact that it is dominated by a handful of sectors, notably oil & gas, banks and pharmaceuticals. That means a downturn in any one of these sectors could have a disproportionate effect on investors’ portfolios. By the same token, investing globally, from a much wider opportunity set, can broaden exposure beyond just a small number of industry sectors.

    However, it is important to think about diversification not only in the context of geographic exposure, but also across asset classes. This is especially relevant in the context of DC, where the goal of diversification should not purely be to bolster returns, but also to spread risk and protect against capital loss. Good diversification entails a well-calibrated investment process that is able, in an opportunistic way, to identify assets with the potential for sound long-term returns, which are going to be genuinely diversified in the future. This is achieved by gaining a deep insight into underlying factors that drive asset-class performance, and by understanding the risk profiles of different asset classes. Dynamically managing those asset-class exposures, not in isolation but in the context of the portfolio as a whole, can help achieve good diversification. But there are diminishing benefits to diversification where excessive or ‘over-diversification’ may harm rather than help your DC strategy. Indeed, diversification is not about having an allocation to every asset class.

    The era of financial repression, quantitative easing and structurally lower returns on conventional assets, has seen many more traditional multi-asset funds evolve from an inflexible mix of 60% equities and 40% bonds into unconstrained portfolios with a flexible mandate to invest in areas including infrastructure, private equity, convertibles, commodities and renewables.

    In our own multi-asset suite, we have not shied away from taking strong positions where we have conviction in a particular sector or asset class. Conversely, in some cases we may choose to have no exposure to a particular area. For instance, guided by our debt burden theme, which highlights how we anticipate relatively low growth and higher economic volatility, we have had a lower weighting to the financials sector than many of our peers, as we see advantages in investing in companies with lower exposure to the cycle, with sustainable cash flows that are not dependent on economic growth. These include certain alternative investments, such as renewable-energy and public-private partnership infrastructure assets, which can offer durable revenues that are government-funded and inflation-linked.

    Conclusion

    In a world where markets have been manipulated by state intervention, and as increasing political uncertainty makes it difficult to ascertain risk, the role of diversification in DC portfolio management is as important as ever. The benefits of diversification across geographic areas, sectors and asset classes have clearly been demonstrated by recent unexpected events such as the UK’s Brexit vote, the election of Donald Trump, and major changes in the oil price. We believe that an intelligent and flexible investment approach, with a disciplined risk process for diversification, can serve to mitigate the impact of such events on an investment portfolio, giving DC schemes some comfort that as members go to and through retirement, their nest egg should not be subject to a significant drawdown.

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    [1] Source: https://www.plsa.co.uk/portals/0/Documents/0619-ESG-risk-in-default-funds-analysis-of-the-UKs-DC-pension-market-260417.pdf

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