Diversified Growth Strategies: Life in them yet?
Diversified growth strategies were first conceived in the aftermath of the tech bubble and have since amassed a huge volume of assets despite initial scepticism. Brendan Maton assesses this heterogeneous universe
At a glance
• Diversified growth funds began to gain traction around 10 years ago as a way for smaller institutional investors to diversify.
• Most seek to offer equity-like returns with around two-thirds the volatility.
• Over 40 managers now offer such strategies with a variety of approaches.
• DGFs are cautious about future returns and exposure to illiquid assets is likely to be a key issue.
If you have not yet heard the term diversified growth fund (DGF) then beware: it could be arriving in a sales pitch very soon. Over £100bn (€140bn) assets have been gathered by such funds in the UK alone, a substantial amount coming from small and medium-sized pension schemes. Nordea is the latest non-UK entrant to join the hunt.
The popularity is justified. Most DGFs have performed well since launch; the longest-standing ones especially well. This means DGFs have, for actively managed investment products, an unusually bright lustre. Such high regard is rare, particularly when there is no fixed methodology or parameters.
Indeed, no two DGFs are alike, according to Alick Stevenson, a senior adviser at Allenbridge, the London-based pension fund consultancy: “They all go about their knitting in different ways.”
His colleague, Steve Tyson goes further. “Everyone is familiar with Standard Life’s GARS – the big daddy of the sector with £45bn in assets under management. Personnel from this strategy have gone to other houses or been poached and yet we find these ‘sons of GARS’ at places like Invesco and Insight to be in fact less correlated with GARS than one might expect.”
Perhaps it is the sheer variety and lack of standardisation of DGFs that has benefited the category as a whole. Their founding mantra was broadly two-thirds of the return of equities for half the volatility. There are few other standard parameters. Some, such as Schroders, have a minimum equity exposure. Others, such as Standard Life Investments, rely more on relative-value trades.
Some funds are entirely managed in-house, such as Columbia Threadneedle’s. Some, such as Baring Asset Management’s, allocate to a mixture of in-house and external managers. Others, such as that of Momentum and those of consultancies such as Mercer and JLT, have no underlying in-house funds; JLT’s invests in DGFs as well as other investments.
In terms of breadth of asset classes, DGFs now include exposure to naturally illiquid opportunities such as infrastructure, property and private equity via real estate investment trusts and funds as well as hedge funds and natural relative-value trades such as between pairs of currencies. But there is no minimum or maximum list of required assets.
Aniket Das of Redington, another London-based pension fund consultancy, notes that more CTA strategies and hedge funds such as Winton Capital are entering into the space.
All, however, face a pressing problem to which multi-asset strategies are periodically susceptible: diversification has not resulted in the highest returns. Over the past five years, global equities have returned more than 14% annualised (see figure 1). Over the same period only one DGF has achieved more than 8% annualised, according to Allenbridge. Most are clustered in the 6–7.5% range. Some pension fund trustee boards are said to regret these lower returns.
“Of course, DGFs are meant to deliver lower absolute returns but higher risk-adjusted performance,” says Das. “But some trustees just want to see the returns.”
Back in time
DGFs were first conceived in the ashes of the millennial tech bubble by John Finch, Kevin Frisby and fellow pension fund advisers at HSBC Actuaries & Consultants, a firm since acquired by JLT. They knew that pension funds needed growth assets but sought a smarter allocation route than piling up equity market exposure. Finch and Frisby were wise enough to know that active management of equities was not sufficient to do the job alone.
Looking at DGF performance over a long period suggests that these funds can do what their originators desired. Over seven years to the end of June, global equities have managed just over 7% annualised, according to Allenbridge. The fact that this was achieved at far greater volatility than any DGF we can overlook for the time being; on performance alone, more than half of the DGFs did better and all but one came close on the single measure of returns.
Allenbridge’s Tyson points out that the seven-year period is important because it includes the financial crisis of 2008–09. He does not predict another such downturn but doubts another six years of generally benign equity returns are on the horizon. “I believe that DGFs come into their own in choppy waters. Although I don’t have a perfect barometer to reliably predict when the water will be ‘choppy’, my sense is that we are entering a period when diversification works again,” Tyson adds.
“Our track record shows that the range of outcomes we’ve produced in good and not so good times has been much more stable than equity-only strategies,” says Michael Spinks, co-head of the Investec DGF, one of those with a solid seven-year track record. “We find institutional investors are looking for more clarity nowadays about the likely returns they will experience than a ‘set and forget’ attitude to asset allocation; leaving it up to whatever equities and bonds do, and hoping their manager will do slightly better.”
Consultants remain wary that the lustre of DGFs masks some disappointments. Alex Koriath of Cambridge Associates claims that between the end of March 2007 and end of March 2015, the median DGF manager lagged a simple 60:40 equity/bond portfolio by 330bps. Gareth Doyle of Hymans Robertson in Glasgow points out that some DGFs under delivered during the financial crisis.
Koriath and Doyle do not doubt the efficacy of some DGFs. Their warning is that in such a heterogeneous universe, variance in performance is inevitable. “While the DGF market growth story has been alluring, all that glitters is not gold,” says Koriath.
Eyes on the road
DGF managers themselves are aware of the challenges they face. Baring Asset Management has been vocal about tougher conditions ahead although in true DGF fashion, the emphasis is on higher risk than lower returns. Since 2003, the firm’s Dynamic Asset Allocation strategy has achieved over 7% annualised returns, net of fees, for almost half the volatility of equities.
Chris Mahon, head of Baring Asset Management’s DAA strategy, believes that the relative risk to equities will be more like 70% than half in the future. “We have overdelivered in the past,” he says.
And although Baring, like several other DGF managers, is currently relatively optimistic about equities, for the long term Mahon is pessimistic because the debts of the financial crisis have merely been transferred from households and banks to central banks, which means a real reckoning has been postponed, not averted. “If you look at the long run, central bank balance sheets and equity markets have a very high correlation,” he warns.
Claus Vorm, deputy head of multi-asset at Nordea Investment Management in Copenhagen says the blanket protection offered by government bonds in the past is not there any more. “The challenge is to find bond-like balances to equity,” he says. His firm sees US longer-dated government debt as one area where European investors can currently benefit from duration. For risk-off environments, Vorm mentions currencies such as the dollar and yen as potential forms of protection.
The Kestrel Global Portfolio run by John Ricciardi and Gustaf Hagerud, former head of investments at AP3 in Stockholm, uses hedge funds as one means to eke out better returns from a low-risk portfolio. “If we can return 3% for a volatility of 4% from [hedge fund] strategies that are uncorrelated to the bond yield, then that is a good idea,” says Hagerud. Kestrel has a low-risk and a high-risk section to its fund and the idea is to vary exposure to the two sections in accordance with beliefs.
Nordea Investment Management has its own proprietorial model, devised by Vorm and Asbjørn Trolle Hansen over 10 years ago, with which they are now targeting the UK in a new DGF. The question has to be why these models will be better than most other models out there in active asset management. DGFs, after all, can be seen as mainstream asset managers’ response to hedge funds. They are cheaper and more transparent but that does not eliminate hubris and its consequences completely.
Hagerud says that skill is a factor and managers have to demonstrate superior interpretation, which he distinguishes from market timing. So, for example, when global investors reacted harshly to falls in the Chinese stock market this summer and devaluation of the renminbi, the common explanation was a loss of faith in China’s ability to keep on growing. But Kestrel was not so negative, interpreting the interventions in the financial markets by the central bank as demonstrations to the IMF that Beijing is preparing and can cope with the ramifications of a freer-floating currency.
One final issue on DGFs regards liquidity. It is possible to get exposure to illiquid asset classes such as infrastructure and private equity via ETFs and pooled vehicles. This has long been the case for property. Such vehicles have benefitted since the financial crisis from regulations that demand greater liquidity. But how does this affect the illiquidity premium? Ben Inker, head of GMO’s Benchmark Free Allocation fund, says that, first off, investors cannot assume an illiquidity premium simply because they invest in private equity. That would be nonchalant. Second, he notes that a high yield bond ETF is likely to contain the most liquid issues. In both cases, there may well be advantages to making the commitment but investors should be wise as to how the chosen vehicle affects the underlying exposure.
In the taper tantrum of 2013, many top quality emerging market debt managers suffered not because investors lost faith in them but because it was the easiest asset to sell in a bad environment.
Here is the kind of paradox for those DGFs that have exposure to a lot of illiquid assets: are they held during any crisis because their value is relatively unaffected by short-term gyrations? Or is their liquidity, via ETFs and pooled funds, so effective that they merely get trampled upon during any panic for the exit in years ahead? The nature of the vehicle and useful characteristics such as daily pricing reduce the diversification merits.
Figuring out how to manage liquid illiquids is just one challenge DGFs face in ensuring their longevity.