Navigating the Diversified Growth Fund Maze

Executive Summary

• The market for diversified growth funds (DGFs), multi-asset investment strategies that often aim for the ambitious goal of generating long-term, equity-like returns with lower volatility, has grown rapidly over the past five years, driven largely by UK defined benefit pension schemes seeking risk-controlled, long-term growth solutions.
• While DGFs share a common fundamental goal, the DGF label is frequently applied to a confusingly varied range of funds with different underlying strategies. Based on their risk characteristics, we identify the emergence of two distinct categories of DGFs, which can help clarify the landscape for trustees. The first, traditional DGFs, rely largely on directional market exposures to generate returns. The second, absolute return DGFs, predominantly emphasise a relative value approach. Both approaches imply distinct risk/return expectations, differing attractiveness across market environments, and varying roles in the broader scheme portfolio.
• Evaluation of historical performance is difficult as benchmarking outcome-oriented solutions such as DGFs can be challenging, and the number of DGF managers has only reached significant size recently, limiting the number of years that can be analysed. Since 31 October 2007, when our universe of DGFs first reached ten funds, the median DGF has lagged a simple 60/40 stock/bond portfolio, although DGFs have generally achieved their volatility-reduction objective and outperformed LIBOR and inflation.
• Rigorous DGF manager selection is essential, especially where the allocation to DGFs is large. Annual performance dispersion across DGFs has been significant, with top and bottom performers often separated by 15 ppts or more. Dispersion shrinks over longer time periods; over the past five years, the spread between the return of DGFs in the 75th and 25th percentile was 110 bps per In the current low absolute return environment, trustees need to maximise their chances of being in the top quartile by adopting a rigorous evaluation approach that leaves no stone unturned.
• DGFs can play a variety of roles in pension portfolios. Schemes can use DGFs as a growth portfolio replacement, dynamic growth core, or liquid diversifier within the growth portfolio. The attractiveness of each role depends on each scheme’s size, governance structure, constraints, and objectives. Trustees must match the desired portfolio role with the DGF strategy and manager selected.
• In our view, DGFs’ aim to generate long-term growth with lower volatility than equities is intuitively appealing for pension schemes, but inherently difficult to achieve. The DGF market is large and diverse, and has delivered mixed results thus far. Trustees need to look carefully to appreciate the variety of DGF strategies, set appropriate risk/return expectations, and evaluate DGFs’ role in the context of the total portfolio. While the DGF market growth story has been alluring, all that glitters is not gold.

Diversified growth funds (DGFs) have been a fast growing segment of the investment product landscape over the past five years, particularly amongst UK defined benefit pension schemes seeking long-term growth solutions without equity volatility. DGF assets under management (AUM) have grown from approximately £100 billion in December 2013 to over £150 billion as of March 2015 by our analysis, and a recent Spence Johnson study suggested that the DGF market could break £200 billion by 2018 (Figure 1).

In the context of this significant growth, the number and range of funds tagged as DGFs have proliferated. As a result, the DGF universe is now extremely heterogeneous and increasingly difficult to navigate. Some DGFs resemble enhanced balanced funds, while others are more akin to hedge funds in a liquid format. Performance and risks vary across strategies, forcing trustees to dig deeper to find the funds suited to their investment objectives.

In this report, we review the DGF landscape and performance track record, categorise DGFs by underlying strategy, discuss risk/return expectations, and explore the roles DGFs can serve within a pension portfolio.

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