Driving change in the DGF market

Diversified growth funds need to significantly improve their performance, according to Alice Lee 

At a glance

• A study of diversified growth funds (DGFs) by Willis Towers Watson found that most met their long-term growth objectives but that returns could by explained by beta.
• Strategic allocation generated value but tactical allocation and securities selection detracted value.
• To stand out from the crowd, DGFs need to offer something different in their asset mix or charge lower fees.

Since its launch over a decade ago, the UK’s diversified growth fund (DGF) market has experienced phenomenal growth.

This came particularly after the 2008 global financial crisis, when investors began to realise the danger of relying on equities to drive asset growth in their portfolios.

Unlike their predecessors, balanced funds, which managed static portfolios consisting of 60% equities and 40% investment-grade bonds, DGFs invest in a mix of asset classes, including high-yield bonds, infrastructure, property and even absolute return strategies, allowing them to achieve superior risk-adjusted returns. Owing to their intended improvement upon balanced funds, a 60/40 global equities/global bonds blended index is sometimes used to informally benchmark short-term DGF performance.

Through a single governance-friendly solution, DGFs aim to deliver equity-like returns with less volatility, typically a half to two-thirds that of the equity market. Most will have explicit long-term, absolute-return objectives referenced to a cash rate or inflation such as from LIBOR or the consumer price index (CPI)-plus 3-5%.  

Although portfolio construction can vary among managers, DGFs aim to own the optimal mix of asset classes that will enable them to achieve their long-term return and risk objectives. 

Many active DGF managers also claim to generate additional value by dynamically altering their portfolios in response to short-to-medium term changes in the market, and aim to generate returns by selecting specific securities to implement their view, for example, using single-name stocks rather than an index. 

Key findings of study

In 2015, Willis Towers Watson conducted an in-depth study of the DGF universe to determine whether DGFs had delivered on their objectives and to assess the ways in which they added value. 

In summary, the study found that most DGFs had met their long-term return objectives since their respective inception dates, with lower volatility than equities. Taking a closer look at the return drivers, we observed that most DGF returns could be explained by their beta to the 60/40 comparator. 

Unsurprisingly, strategic asset allocation generated the most additional value, where holding a wider range of assets was beneficial. However, tactical asset allocation and securities selection detracted the same amount of value.

Our study raised two questions: if the main driver of DGF returns is strategic asset allocation, are investors paying appropriately for this; and, how easily can this be accessed by investors? We believe that strategic asset allocation is more commoditised today with many DGFs providing access to a similar range of asset class exposures. To stand out, DGFs should either offer something different or charge lower fees similar to index-tracking implementation DGFs, which also provide access to a broad range of asset classes.

What could DGFs do differently?

Below we highlight some ways in which DGF managers could innovate their offerings and improve net-of-fees performance: 

• Expand the toolbox: We have historically observed a heavy reliance on equities to generate growth, often at the expense of new strategy research. We would like to see managers make more use of alternative asset classes and strategies, including smart beta and illiquid assets. These should ideally be less correlated to traditional equities or corporate bonds.

• Greater use of externally managed funds: Often, DGFs allocate only to internally managed funds, which limits access to best-in-class strategies. By looking beyond in-house offerings, DGFs could increase portfolio diversity.

• More efficient implementation: DGFs could use indices to gain market exposure at a low cost if security selection is unlikely to add much value. Alternatively, provided a manager is skilled in security selection, customised baskets of securities can allow for top-down views to be better incorporated. 

• Better risk management: Multi-asset portfolios are exposed to a variety of risks and it is important that managers have robust risk-management processes that enable them to monitor and control unwanted exposures. In addition, active hedging strategies can add value by protecting the fund from large absolute drawdowns and, over time, the compounding effect can lead to outperformance versus peers.

• Charge fees that are commensurate with skill: The average DGF charges fees that are too high relative to its skill, with returns being mostly driven by its allocation to equities and bonds.

Getting the most out of DGFs 

DGFs with implementation through index tracking can help investors achieve growth at a low cost over the long run. While they generally exhibit lower volatility than equities, they may be subject to larger drawdowns than actively managed strategies. For investors who wish to avoid complexity, who have tolerance for higher volatility and who are fee sensitive, index-tracking implementation DGFs could be the optimal route.

With access to a broader range of tools, actively managed DGFs remain a good option for investors who have higher return targets and desire greater drawdown protection. However, we encourage investors to consider whether these managers are really adding value through tactical asset allocation and security selection.

In summary, achieving value for money should be the goal of all investors. To this end, we encourage the judicious use of active DGFs since, as our study revealed, there are many managers that add little value. This does not necessarily mean that cheapest is always best.  

The quality of the DGF investment team and the robustness of the investment process should remain important considerations for investors, along with an appreciation of a DGF’s risk profile and fit with an incumbent portfolio.

Understanding their limitations 

A well-known drawback of DGFs is their inability to offer daily liquidity – a key requirement in accessing UK defined contribution schemes. This limits flexibility to capture the illiquidity premium, which can be a powerful diversifier in a traditional portfolio. 

An investor who can accept a less liquid strategy could choose a truly diversified multi-manager approach that covers the full spectrum of alternative asset classes and makes extensive use of best-in-class managers.

We also note that successful products have inevitably attracted significant assets over the years. We believe that assets under management is not a reflection of future success and we have reason to believe that weak growth discipline can actually lead to skill being diluted. 

Investors have an important role to play in the evolution of the DGF offering. By discerning between genuine skill and market beta, much of which are now broadly accessible, investors can use their buying power to urge managers to create more modern, cost-effective and better-structured solutions.

Alice Lee is an investment consultant at Willis Towers Watson

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