Spreading the risk
Diversified growth lives up to its name, covering a diverse range of institutional strategies with diverse potential uses for pension funds, finds Christine Senior. But is the strategy discredited?
Diversified growth is a broad church. The term encompasses an enormous range of different products that all fit under the same umbrella but vary greatly in their
composition and the strategies they use. Their performance and how trustees use them varies too. "When you invest in an equity you know what you are going to get," says David Clare, head of investment consultancy at HSBC Actuaries & Consultants. "Diversified growth, on the other hand, is a concept that is applied quite differently by one manager and another. Some do very aggressive asset allocation; some take long-term strategic portfolios. We've found that managers who've been running tactical asset allocation products often change the branding to diversified growth to get a wider target audience. We advise ‘diversifying the diversified growth managers'."
Consultancy firm Lane Clark & Peacock sets them in three categories, ranging from passive beta at one extreme, through active beta to target return. Passive beta funds are composed of fixed allocations to equities and a range of other growth asset classes, with constant re-balances back to the strategic allocation. The mix may include commodities, property, hedge funds, currencies, private equity alongside equities.
Active beta has a similar mix but gives the manager more leeway to vary allocations. Some funds might use market timing to switch between equities, bonds and cash. Some are designed to capture beta, while others are alpha-seeking and some combine the two.
At the target return extreme, the manager has the discretion to use his skills by taking big positions in a single asset class or even selling out of equities completely. An example is the multi-asset class absolute-return strategy offered by Union Banque Privée, which invests in equities, high grade fixed income and hedge funds.
"The combination of those asset classes rolls up to give us a product of low volatility to target a LIBOR-plus objective," says Nicholas Lewington, UBP's head of absolute return strategies. "Typically the risky side is pure equity plus a fund of hedge funds. You could argue that it is a kind of diversified growth portfolio."
Most would agree that diversified growth funds aim to achieve equity-like returns with less volatility, normally benchmarked to LIBOR or to RPI. "You aren't going to hit the peaks when the equity markets perform well but in giving up the peaks you expect to avoid the troughs," says Adam Brown, executive investment consultant at KPMG. Sure enough, target return funds pulled off decent performance over 2008, because managers had the flexibility to retreat to safer havens.
"Last year target return managers concerned about the meltdown went into defensive assets and currencies," says Kevin Frisby, a partner at LCP. "The yen, the Swiss franc, into gold, cash, short-dated government bonds - managers aren't concerned about owning those on a short-term basis."
But last year was also remarkable in that it suggested that the fundamental diversification argument didn't work. Is the strategy discredited?
"Because a diversified-growth strategy aims to meet a return target, you need return assets in your portfolio," says Ewen Cameron Watt, managing director of BlackRock's multi-asset portfolio strategies. "This means that you have to accept that sometimes you will lose money, and there may be exceptional periods where correlations converge to 1.0. With that proviso in mind, we believe diversification remains an important feature of the strategy, as having different volatility and return characteristics in the portfolio will help control overall volatility."
Even if some types of diversified growth funds failed to perform during 2008, solid arguments support their effectiveness over the longer term. "There is confusion on the part of some investors about what diversification means," says Mark Humphreys, of Schroders' strategic solutions team. "The smoothing process works over a period of years and you really will see the benefit over years. Pioneers like Harvard in the US had a bad year, but that doesn't invalidate what they were trying to do."
To provide more transparency on short-term performance, F&C Asset Management has devised an internal benchmark that enables investors to check its diversified growth fund's performance more frequently, although the fund's objective is LIBOR plus 3-4% over five years. "We can be assessed against that benchmark monthly, so consultants can judge what is being driven by our skills and what is being driven by the market," says fund manager Toby Vaughan. "Last year we had significant drawdown, but we didn't have exiting clients. They knew the time horizon they were going for."
Of the various diversified-growth strategies on offer, it is the target return funds that appear to be garnering the most interest from pension funds. These funds have a place in both defined benefit and defined contribution schemes. DB scheme trustees are turning to target return funds as an alternative to equities in their portfolio, attracted by the diversification opportunities. But, additionally, they may also be used to complement equities.
Frisby argues for their role as part of a swaps-based LDI structure. "A strategy which is designed to generate LIBOR-plus marries nicely with LDI," he says. For resource-strapped funds, diversified growth is a useful means of accessing a wider range of assets than they would otherwise be able to.
In DC schemes, diversified growth is also finding favour as the default option, often in conjunction with a lifestyling arrangement. As an alternative to a pure equity fund, or as part of a 50/50 split with equities, diversified growth funds give investors the chance of building up their pension pot with lower volatility. Schroders' diversified growth fund evolved as an element in its own DC pension scheme. This targets 70% of return from holding a range of markets, with the remainder using a dynamic asset allocation strategy to invest in different growth assets depending on the phase of the economic cycle.
"Over the lifetime of a DC investor, 20-30 years at best, equities can disappoint with high probability," says Humphreys. "We have no formal benchmark to different parts of the world or asset classes. People like the idea they are not locked into a particular region. That added protection is quite attractive."