Katherine Lynas and Adam Gillespie point out that strong diversified growth funds distinguish themselves in performance terms at times of heightened market stress
Types of DGF
• Diversified: Managers gain their return and reduce risk through diversification of broad asset classes. Returns are primarily beta-driven.
• Dynamic: Managers move swiftly and opportunistically into primarily traditional asset classes.
• Complex: Managers are able to take short positions to make gains from relative price movements. Returns are dominated by alpha and/or alternative risk premia.
• Algorithmic: Managers implement a quantitative process, with minimal human intervention, with the intention of removing behavioural bias in decision-making.
We all know diversification as one of the inalienable rules of portfolio construction. At its most basic level, a well-diversified portfolio can smooth out returns over time and, in some cases, even help to improve returns. But while the theory of diversification may be sound, historically the practice is much more difficult, particularly as the pace of markets speeds up and the correlation between asset classes rapidly changes. However, the increase in diversified growth funds (DGFs) presents schemes with an opportunity to access tailored diversification strategies.
Historically, pension schemes looking for a simple diversification strategy invested in balanced funds. These typically held equities, bonds, property and cash in relatively fixed proportions. While this achieved some diversification, the range of asset classes was limited and there was little scope for an active element; managers struggled to access potentially lucrative investment opportunities or exit potentially risky ones as market conditions changed.
Before the 2008 financial crisis, correlations between asset classes used to change gradually. This gave investors the time they needed to develop their assumptions, re-calibrate their models and adjust asset allocations. But the crisis reinforced the fact that the market had sped up. Nowhere is this more evident than in the development of buzz words such as ‘dynamic correlation’ and the fact that managers now monitor correlations on an on-going basis as a key part of risk management, as opposed to on an annual basis as was previously the case.
The experience of 2008 alerted investors to that fact that new ways and forms of diversification were required. The response came in the form of dynamic asset allocation funds. These funds provided a more active approach, allowing investors to react quickly to potential opportunities and to protect capital values when asset classes looked likely to fall. These funds subsequently developed into what we now know as DGFs.
The challenge facing schemes is not how to diversify, but the way in which they diversify. At present, there is no formal definition of DGFs and every approach is slightly different. However, we consider the appropriate funds for schemes to be those that aim to achieve equity-like returns with one-third to two-thirds of the volatility of equities. With so many approaches to choose from, the diversification choice for pension schemes is far from simple. So what options do schemes have and how can they find a DGF which is suited to their needs?
In analysing the DGF universe, we can broadly divide funds into four categories. The categories are: diversified, dynamic, complex and algorithmic (see panel).
Owing to their mechanistic nature, algorithmic funds are an unsuitable investment for pension schemes and so we focus on the remaining three types below. In these different styles, pension schemes have an array of options to tailor their diversification strategy to their wider strategic objectives.
Funds in the diversified category are typically relatively simple, relying on diversification and market returns to achieve their returns and manage their risk. Over the past five years, as returns on the main asset classes were relatively strong, this has led to strong performance for these funds, although performance over shorter timescales at periods of higher correlations has been variable. Figure 1 shows that the equity beta – the level of correlation of the fund with the equity market - on this type of funds is relatively high.
Dynamic funds tend to use more active management and more sophisticated investment techniques. Over recent years this has allowed these funds to manage to lower their risk relative to diversified funds, but at the cost of slightly lower returns.
The third category, complex funds, uses more complicated investment processes that can include relative-value techniques, which means that theoretically they are less exposed to overall market movements and the returns are more dependent on the manager decisions. They should also be less correlated to conventional markets and therefore are a good diversifier within a portfolio that holds equities and bonds elsewhere. Since 2011, these funds have shown the lowest levels of risk, and corresponding lower returns, out of the three main types of fund. As can be seen in figure 1, the correlation between this type of fund and equities is relatively low, indicating that key drivers of this fund are not equity-linked.
While the performance of many DGFs is similar a lot of the time, strong funds differentiate themselves at times of stress, with the distribution of returns widening, as shown in figure 2 below. Out of a selection of 42 DGFs, the range of returns in June 2016 was 7.6%, the widest in the previous three years and compared to an average of 4.0%. Also of note is that under relatively normal circumstances the performance of global equities is within, or at least not too far outside, the DGF performance range. However, in June 2016 – a month of great uncertainty – global equities vastly outperformed all DGFs. It would be wrong to draw conclusions from performance over a single month and in any case we would not expect DGFs to keep pace with equities when equities rally strongly. However, it is a reminder that even the most prepared (and diversified) can be hurt by the unexpected.
In markets where either equities or bonds (or both) are performing well, it is generally not difficult for DGFs to perform reasonably well in absolute terms. Although recent market conditions have proved more testing for some DGFs, those with robust investment processes and risk management techniques have performed in line with expectations, providing a smoothed return and lower risk compared to equity investment.
For pension funds, the nuances in approach provide an opportunity to achieve bespoke diversification tailored to their wider strategic objectives and direction. We continue to believe that DGFs have an important part to play in investors’ portfolios and, given there is such a huge range, schemes should have no difficulty in finding a diversification approach that is perfectly suited to their needs.
Katherine Lynas is head of manager research and Adam Gillespie is a principal at Punter Southall
Pensions In UK: Of Brexit, deficits and LDI
- Currently reading
Diversified Growth Funds: Diffusing the risk