July-August 2014

PENSIONS: Anyone for a DGF?

MacaroonsDiversified growth funds are handy way to spread risk while reducing portfolio volatility. Bit for both DB and DC pension schemes, there are some drawbacks. George Mitton reports. A pension scheme wants to reduce the volatility of its portfolio. Another is nearly fully funded (lucky for them) and wants to reduce risk. A third wants to reduce its exposure to “expensive” bonds. For each scheme, a diversified growth fund (DGF) could be the correct solution. A diverse segment, these funds typically invest in a variety of asset classes, aiming to achieve attractive returns with low volatility. DGFs have become popular since the financial crisis as investors have become more troubled by volatility.  But are they the best tool for pension schemes? SCEPTICISM
One concern is that despite their stated aims to spread risk across a range of asset classes, many DGFs display a significant correlation with equities. “Sometimes the diversification isn’t really what it’s cooked up to be,” says Matt Roberts, senior investment consultant and portfolio manager in the delegated investment services team at Towers Watson. “A lot of the funds that are available are quite equity biased, even though they are DGFs.” It is difficult to generalise because diversified growth funds are diverse; a report by research firm Spence Johnson found huge variations in equity allocations between DGFs, from more than 60% of the portfolio to less than 20%. However, for those funds which do move in line with equity markets, it’s worth questioning whether pension schemes are getting value for money, especially given that DGF fees are much higher than, for instance, those of passive equity funds. The question of cost is also relevant to defined contribution (DC) pension schemes (see box). A related problem with some DGFs is that although their performance is correlated with equity markets, they tend not to perform as well as equity funds in growth markets. This is understandable, since DGFs aim to limit losses and volatility by sacrificing some performance gain. However, for pension schemes in need of growth, there is a risk that DGF performance could disappoint. “For many DGFs, success is hitting 4%, but most pension funds, to the degree that they need growth, need their growth assets to deliver 5-7%,” says Charles Marandu, director of European institutional advice, SEI Investments. “You end up with the situation where the DGF manager tells you they’re doing well, yet your liabilities aren’t being met. There’s a disconnect.” The question of liabilities – the overarching concern of all defined benefit (DB) pension schemes – explains a further objection to DGFs, which is that they are not a liability driven solution. This isn’t a failing – DGFs do not claim to take into account pension scheme liabilities – but in some consultants’ eyes, this does make them less appropriate for some clients than a liability driven investment (LDI) service and, perhaps, fiduciary management. Consider, for instance, that DGFs typically have a benchmark based on Libor or the Bank of England base rate, and aim to exceed these indices by 3-5%. “I’ve never seen a pension scheme discount liability to the Bank of England base rate or Libor,” says Marandu. ILLIQUIDITY
Another reason why DGFs might not always be the ideal instrument for pension schemes is that they are compelled to be liquid. Yet DB pension schemes, because of their long liabilities, have an enviable ability to invest in asset classes precisely because they are illiquid. “Pension funds have a perception that they need liquidity far more than they do,” says Antony Barker, pensions director at Santander UK. “It’s a false perception. Our fund’s liabilities have a 23-year duration and we have a pay-out for some 50+ years. We’ve set our broad asset allocation to reflect us not needing everything to be liquid.” Barker is sceptical about DGFs and one of his arguments is that pension schemes can achieve a better return by doing their asset allocation themselves and deliberately locking up some of their portfolio in alternative asset classes, such as private equity or infrastructure, which will promise an above market rate of return in exchange for illiquidity. In contrast, DGFs often gain exposure to these asset classes using derivatives. Barker says there are other reasons to be suspicious of DGFs. One is that providers of these products often do all or most of the investments in-house. That may make sense from an operational perspective, but it raises questions about whether the client is getting the best return possible. “If you’re designing a fund that is completely managed by in-house teams, you’re not getting best in class,” he says. “It’s a marketing tool. It adds administrative simplicity, and might help on the cost perspective, but people shouldn’t be kidded.” In short, Barker believes it is unrealistic for a single asset manager to be the best manager across all asset classes. Alternatively, for those providers that do appoint external managers for certain asset classes, it is important to be clear that there is no “layering” of fees, which can happen in a fund of funds format. SMOOTHER OUT
Although there are reasons to be sceptical of these products, DGFs can still have a place in pension scheme portfolios. Perhaps the question is merely where they fit in with the other investments a pension scheme has. One argument in their favour is that DGFs can achieve growth at significantly lower levels of volatility than equity funds. Indeed, many DGFs use this factor – low volatility – as their main selling point. “They’re a smoother-out of risk,” says Rob Barrett, institutional sales manager, Invesco. “That’s what people use them for.” Another point in favour of some providers of DGFs is that a number of fund companies do employ external managers for those asset classes in which they are not best equipped. The policy is essentially an admission that the fund provider is not the best at everything, and demonstrates a commitment to try to get the best return for clients. Henderson Global Investors, which uses external managers for its DGF, says it is careful that external managers do not burden the fee on the fund, which is currently 80 basis points. “Transparency on fees with these strategies is really important,” Nick Adams, head of institutional in European Middle East and Africa at Henderson Global Investors. “We show what the additional expenses are in our strategy and ensure it’s capped at a certain level. These are included in the total expense ratio.” Perhaps the most appealing aspect of DGFs is that they can allocate between asset classes quickly, in theory taking advantage of opportunities to increase the fund’s return by tactical asset allocation.  Pensions boxAlthough some pension schemes have dedicated staff in charge of tactical asset allocation, many do not have a large enough team – or, alternatively, they find that their trustee board does not approve decisions fast enough – to do tactical allocation seriously.  For these schemes, DGFs can offer a solution. “To create the same exposure you get in a DGF through individual building blocks takes time,” comments Hannah Sparrow, global multi asset group, JP Morgan Asset Management. “This type of portfolio takes it out of people’s hands. It’s being managed by a team of experts who are experienced at asset allocation,” she adds. These qualities are justifiably appealing to pension schemes, both DB and DC, and explain why DGFs continue to occupy a substantial portion of portfolios. New DGFs are hitting the market regularly – see Aviva Investors’ offering, launched under its new chief executive, who was one of the architects of Standard Life Investments’ hugely popular GARS fund.  This suggests this product segment will continue to attract inflows in future.  Maybe that is no bad thing, though pension schemes should consider carefully whether their needs are properly met by these products, because there are other options out there. ©2014 funds europe

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