While there are some clear advantages to diversified growth funds (DGFs) investing and they remain a key building block in portfolio construction for certain types of asset owners, Willis Towers Watson has warned that the majority of investors should review their perspective on multi-asset investing.
In the consultancy’s 2016 paper – Diversified Growth Fund investing: Is there a better way – the firm highlighted that the DGF market was becoming saturated and wasn’t delivering against expectations. The firm urged investors to investigate a “better way”. At a time of high popularity for DGFs, its paper and its suggestions attracted mixed reviews, said Katie Sims, head of multi-asset growth solutions.
”Fast forward to 2019 and the conclusions from our 2016 paper remain valid, indeed the results of the updated analysis look worse,” she explained. “While some clear exceptions exist in this market, the average DGF is trailing performance expectations and failing to add value.”
Also, in the vast majority of DGF portfolios WTW has seen low levels of portfolio breadth and thus limited scope to outperform a 60:40 equity:bond portfolio going forward.
In a new report – Multi-asset investing: the next generation – Sims claims DGFs started gaining prominence in the early to mid-2000s evolving from traditional “balanced” equity/bond funds.
DGFs invest across a range of asset classes, with the typical goal of achieving equity-like returns with lower volatility, over the medium to long term. Managers typically have broad discretion, with the flexibility to implement through a combination of passive, active, internal and external manager funds, while overlaying asset class views directly.
WTW analysis suggests that approximately 70% of leading UK multi-asset funds have failed to meet their return target.
Unfortunately, this disappointment in DGF outcomes extends even to the risk dimension, Sims said. The average DGF has achieved no lower volatility than a simple portfolio comprised of 60% equity, 40% bonds.
”While the DGF market segment is by no means unique among active investment strategies in its average underperformance, we believe that as a category it could do much better targeting a wider breadth of opportunity set and exploiting greater specialism in security selection in order to address the mediocre returns achieved historically.”
Constrained opportunity set
During a recent survey of the manager universe, the average DGF had around 17.5% invested in alternative asset classes. ”We view this as low in the context of the return and risk goals of an average DGF and the discretion afforded,” Sims said.
The allocation to alternatives can be viewed as a crude bellwether for the degree of diversity and stock selection return potential in a DGF, She said, adding that the scope for differentiated insights is greater in less efficient and less followed “alternative” strategies.
”Furthermore, our analysis reveals that a larger allocation to alternatives within DGFs is typically indicative of higher long-term returns. In practice, it can be difficult to implement a larger allocation in the DGF market given how current product design typically seeks to comply with (some) regulatory restrictions.”
The low allocation to alternatives is heavily influenced by regulatory constraints imposed on liquidity and fee requirements for certain types of client, she went on.
Given the popularity of DGFs in defined contribution pension schemes, unit-linked life funds are a common vehicle for them. In the UK, this vehicle structure is governed by the Financial Conduct Authority’s Permitted Links rules, which cover capital limits on relatively illiquid strategies.
Current discussions around the relaxation of these rules are encouraging, Sims noted, as an ease of these constraints could effectively broaden the opportunity set available to long term asset owners that may be sacrificing the illiquidity premium, and therefore additional return.
Mercer forecasts quadrupling of UK bulk buyouts over next decade
Mercer has forecast accelerated growth in risk transfer over the next decade, with the bulk annuity market expected to quadruple compared to the current decade, which saw £135bn (€160.6bn) paid to insurers. The growth is expected to be driven by a combination of factors, but mainly lower pricing as more schemes mature and additional reinsurers enter the UK market.
David Ellis, partner at Mercer, said: “The next few years are looking bright for those schemes wishing to insure their members’ retirement income. As the UK’s defined benefit schemes mature, the length of insurance contracts reduce, making them more predictable and cheaper to buy. Despite the increased demand, there is still capacity in the market for well-prepared schemes.”
He added that schemes that want to take risk off the table “need to do their homework before they approach insurers”.
Key steps include understanding the range of options available and choosing the best approach for the scheme, putting the right governance and decision-making structures in place and getting data and benefit information ready for transaction.
By the end of 2019, Mercer expects the bulk annuity market to exceed £40bn, with the total UK risk transfer market – including longevity swaps – expected to hit £50bn. Mercer has also seen strong demand for member option exercises, with a total of more than £20bn of individual DB to DC transfers, both via bulk exercises and individual requests, expected by the end of the year.
In a year of record-sized transactions, including around a dozen over £1bn – including a £7bn longevity swap – Mercer has also seen significant activity at the smaller end of the scale. Alongside its work on larger transactions, the firm has led on dozens of transactions under £50m in liabilities.
Ruth Ward, principal at Mercer, said: “Our acquisition of JLT earlier this year consolidates our leadership in this space. We can now bring our risk transfer expertise to hundreds more DB pension schemes.”
She said that smaller schemes are “certainly having to work hard to gain traction with insurers, but there are great opportunities for those who are well-prepared”.
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