Should funds get on board with DGFs?
Roxane McMeeken investigates whether pension funds should join the race to invest in diversified growth funds
“I have taken diversified growth funds to 12 pension fund clients and they were adopted by 11 of them.” So says Jenni Kirkwood, principal at investment consultancy Mercer.
Indeed, since the first generation of DGFs was launched in 2006, they have grown to £45bn in assets under management in the UK, according to PiRho Investment Consulting. Of this, 83% of DGF investment is with just ten vehicles.
Such is the seemingly unstoppable rise of DGFs that 70 of the FTSE 100 companies now offer them as part of their defined contribution pension range.
I have taken diversified growth funds to 12 pension fund clients and they were adopted by 11 of them
So what is the appeal of DGFs? The key is realising that they are not a homogenous group.
Buck Consultants’ managing director, global investment consulting, Steven White says: “DGF has become a popular acronym to attract defined benefit and DC schemes but it covers quite a wide range of types of fund.”
The funds range from high risk, exotic funds investing in different markets and currencies to more conservative investments. Of the latter, there are “funds investing in growth assets within the categories of equities, bonds and property” and then even lower risk options amounting to traditional balanced funds.
there is no concrete definition of a DG
This diversity means there is no concrete definition of a DGF, as shown by the debate over the number of DGFs, with the number ranging from 40 to 100 or more.
This causes problems when trying to assess the funds. Nicola Ralston, director and co-founder of PiRho, says: “Many people talk about DGFs as if they are a single sector, but this is not true.
“Some say, for example, that multi-manager funds should be included while others say they are a universe in their own right.”
DGFs also have a variety of benchmarks and target returns.
The funds tend to be benchmarked against either cash or Libor the interest rate at which banks lend to each other, with targets ranging widely:
Mercer’s Kirkwood says the majority range from 2 to 5% above Libor. It is important to keep this in mind when considering DGFs.
Some useful performance data is available, however. PiRho has identified 59 DGFs available in sterling. (Ralston says this does not include multi-manager funds, which would expand the number hugely.)
The consultancy has found that over the past four years the funds generally fulfilled their promise of delivering lower volatility than equities: almost all achieved half the volatility of the FTSE All-World equity index.
However, of the 59 funds, only 31 have a track record longer than four years. Their history may seem impressive but is too short to tell us much about long-term performance.
70 of the FTSE 100 companies now offer DGFs
In fact, PiRho’s research has exposed disappointing performance. Despite the universe of 59 funds that claim to deliver less volatility than equities, only 50% of the DGFs have reached their performance objective of equity-like returns. More worryingly, most are benchmarked against Libor and have missed their Libor-plus target.
Ralston also warns that the lack of a formal universe creates a “survivor bias”. In other words, funds that have not performed well may have been quietly closed down. This means that we only have records of the more successful funds.
There is more consistency in DGF fees, which tend to be around 70 basis points, i.e 0.7%. While this is lower than hedge fund fees, it is higher than many equity investment options and expensive compared to index-tracking funds. Whether this is a fair price depends on the DGF. For example, a DGF with a high proportion of equities – say 50% – may turn out to deliver lesser results than a straight equity investment when fees are taken into account.
Kirkwood warns that schemes should watch out for funds calling themselves DGFs while being little more than traditional balanced funds, i.e. the funds, popular until the downturn in 2008, that split investments roughly equally between equities and bonds.
Some DGFs may also come with charges that will further offset any benefits they bring. Allianz Global Investors’ head of consultant relations (Europe) Philip Dawes says: “Investors need to be mindful of the charges associated with DGFs, such as disinvestment charges [when you withdraw your investment] that can have a material impact on scheme members at retirement.”
Some of the risks
It is also essential to be aware of asset manager risk. Russell Investments’ head of investment solutions David Rae says: “As with all active strategies, the fund’s performance could be dependent on a particularly strong asset management team.” It is therefore essential to monitor the fund, particularly to flag up the departure of any key managers.
Another issue, especially with DGFs that invest in a very broad range of asset classes, is whether one asset management house has the sufficient depth of experience. Rae says that although DGF managers often tackle this by outsourcing the management of less familiar assets, whether they have the expertise to monitor those managers properly is another question.
and some of the rewards
DGFs are useful above all for smaller schemes, which typically have smaller pools of assets. This means they are often unable to diversify as effectively as larger schemes.
Smaller funds are also unlikely to have a sufficiently large governance budget, or may not have the necessary in-house expertise. A DGF can solve all these problems, providing a richer diversity of investments and a highly active allocation strategy. PiRho’s Ralston says: “It’s more cost effective than appointing a number of specialist managers.”
A DGF strategy can be appropriate for other scheme types, too. Kirkwood says she has seen DC schemes allocating as much as 100% of their funds to DGFs as a cost-effective approach to outsourcing fund management. Other schemes have limited DGFs to 25% of their growth portfolio, seeing them as one tack among several strategies.
Kirkwood sees DGFs as a “good option” for the DC default fund, too. With these funds traditionally having invested in passive equities, DGFs can be seen as a reasonable alternative for their lack of volatility.
Safe access route
The best way to access the benefits of DGFs while minimising risk is to avoid putting all your money on one horse. Dawes says: “Apply the principle of diversification and find DGFs that are minimally correlated to each other.”
Apply the principle of diversification and find DGFs that are minimally correlated to each other
Ralston says: “DGFs are not alike. Look at whether the fund is stable and less exciting in the good years or more ‘hedge fund lite’ where manager selection is crucial, because they will be taking strong views on all sorts of issues.”
It is also crucial to continue monitoring DGFs after an allocation has been made. Dawes says:
“Trustees need to ensure it continues to do what it promised and given the changing maturity profile of their fund, to ensure DGFs are still appropriate.”