I am back in the UK talking about our defined contribution (DC) scheme for the UK pension plan. We are discussing managers. I am relatively new to this DC world, but how different can it really be? My colleague from the Wasserdicht UK DC pension scheme is Joe and he says we should not worry because he knows his onions. People say the Dutch and English can be very alike but just to be clear: in Holland we are not focused on onions. He briefs me before we see two managers.
“Well Pieter, in the UK we have things called diversified growth funds (DGF) and target date funds (TDF)”. “Please explain.” “DGF gives us exposure to a very large array of asset classes to provide diversification, TDFs will gradually decrease equity exposure over time as you near retirement, and focus on fixed income.” “In theory that is good.” “But Pieter, in practice good too. Everybody is beginning to follow the DGF sector and most will employ these sorts of managers unless they go passive.” “Are we seeing any passive managers?” “No just DGF and TDF.”
The first manager arrives. The marketing chap is all smiles and the investment person wary. They talk about diversification and the ability to switch quickly between asset classes. It seems just the panacea. Joe beams and our guests relax. But I am not happy. “Please forgive my Dutch curiosity, but do you think your fund might be over-diversified?” “What do you mean?” “Well, what is your fund’s correlation to equities? What is each component’s correlation to equities?” “Not sure. We’ll get back to you,” says the marketing chap writing furiously. “My point is that if the correlations are at 80%, which I think they might be, I am not getting the optimum Sharpe ratio.”
Manager number two is next up. Joe says that TDFs are all the rage. We Dutch can understand ‘rage’. The key point with this firm was that at nine years to retirement only 60% would be in equities and global bonds would account for most of the remainder. I ask a question. “And in global bonds there would be allocations to corporates and high yield?” “Yes, but mostly sovereign debt.” “And the correlation to equities is?” Vacant stare. “I am not sure, that is a very good question. We will get back to you.” “Why do you ask?” says marketing man. “Well if our allocation of capital is 60-40, I bet you our allocation to risk is still over 90% equity.”
They leave and Joe looks at me. “You think we have a problem.” “Yes.” “Neither approach really works in high volatile environments. With equities losing 30% in a period of high volatility, neither offers any protection.” “There needs to be efficient diversification. I also want to see ideas about hedging against inflation.” “So you don’t want our staff to peel away the onions?” suggests Joe. “No, it will just make them cry.”
Pieter Mullen is investment director at Wasserdicht Pension Funds