They may be among the most popular investment products for pension funds – but DGFs are struggling to outperform even the simplest traditional balanced fund
London, UK (October 12, 2015) – Pension funds and other institutional investors should be wary of rushing into diversified growth funds, according to Cambridge Associates.
Diversified growth funds – DGFs – have been one of the most popular investment products over the past five years. By March 2015, they had attracted £150bn of assets – up from £100bn just 15 months before. By 2018, they are expected to break through £200bn.
But Alex Koriath, head of the UK pension practice of Cambridge Associates, which advises more than 1,000 institutional investors and private clients, warned: “While the DGF market growth story has been alluring, all that glitters is not gold.”
In an analysis of DGF funds active since October 2007, when its database first included 10 funds, Cambridge Associates found that the median fund lagged a simple, old-style balanced fund with a 60:40 ratio of equities and bonds.
He added that DGFs—which often have ambitious inflation-plus targets—might fail to meet these targets if central banks sanction a rise in interest rates. Most of the DGFs reviewed by Cambridge Associates were not constructed in a way that would deliver inflation-plus returns.
DGF’s Mixed Performance Undermines The Marketing Pitch
The idea behind DGFs is to generate alpha by diversifying across different kinds of growth assets – including equities, bonds, publicly listed real estate and private equity, commodities, and currencies. With the freedom to roam across asset classes, it is hoped that investors can enjoy long-term, equity-like returns with lower volatility.
This has appealed to UK defined pension schemes as they have searched for risk-controlled, long-term investment solutions with a simple governance structure.
But Mr Koriath said: “In our view, the DGF’s aim to generate long-term growth with lower volatility than equities, while intuitively appealing for pension funds, is inherently difficult to achieve.”
In a survey of the 35 DGFs which each had at least £30 million of assets – the minimum size of fund regarded as “investable” for pension funds – Cambridge Associates found that the median DGF manager lagged a simple 60:40 portfolio by nearly 330 basis points – 3.3 percentage points – between 31 October 2007 and 31 March 2015. That equates to £37 for every £100 invested at the beginning of this 7.5 year period.
Large Dispersion of Performance between the Best and the Worst Funds
As well as the big difference in performance between DGFs and balanced funds, Cambridge Associates has found a big difference between the best and worst DGFs. Over the past five years, the top 25 per cent of funds outperformed the bottom 25 per cent of funds by 110 basis points per year.
Over a shorter period – the one year to March 2015 – the difference between the best and worst performing funds was even starker: 26 percentage points, or a staggering 2,600 basis points.
This is significant, especially for smaller pension funds using DGFs as the only growth investment in their portfolios. As Mr Koriath said: “Even a moderate return differential between DGF managers can be impactful in the low absolute return environment that trustees face today. But these are really quite enormous differences in performance.”
Those pension funds that invested in a 75th percentile DGF five years ago gained £7 more than those that invested in a 25th percentile fund for every £100 of investment.
“This dispersion of performance really goes to show that if you are intent on investing in DGFs, you need to devote time and resources to the selection of the right fund manager,” said Mr Koriath. “This will become an increasingly critical task as the number of DGFs grows.”
Inflation-linked Return Targets Are “Mostly Aspirational”
A range of DGFs have return targets expressed as inflation-plus (for example, the Retail Price Index +4% per year). In most cases, we believe these targets to be aspirational at best. From what we have encountered, most DGF fund managers really focus on an absolute return number.
Mr Koriath said: “An inflation-plus target can sound appealing to pension schemes with inflation-linked liabilities. However, for most DGFs, we found very little evidence in the portfolio construction—such as a large proportion of inflation-linked assets or inflation-swap programmes—to suggest that they are aiming to achieve an explicit inflation-plus target.”
He added that this is confirmed by historic returns—where the median DGF was highly correlated to a 60:40 mix of equities and bonds mix but exhibited little or no link to inflation.
The One Bright Spot: Absolute Return DGFs
The analysis by Cambridge Associates found that while DGFs share a common fundamental goal, the underlying strategies they pursue and the resulting composition of their portfolios are highly diverse. “This makes it increasingly difficult for pension fund trustees to compare funds and – ultimately – to know what they are buying,” said Mr Koriath.
To provide some guidance for trustees, Cambridge Associates sees two types of DGF emerging: “traditional” DGFs that resemble a mix of the old-style balanced and tactical asset allocation funds, and “absolute return” DGFs that aim for less directional exposures and use more leveraging and shorting as part of their portfolio construction.
Mr Koriath said: “For pension funds seeking to diversify away from equities, evaluating DGF’s performance during positive and negative periods for equity markets is crucial – and difficult to do given most DGFs’ recent start dates. Absolute return DGFs, however, may be more likely to diversify equity-biased portfolios and zig when equity markets zag.”
For an interview with Alex Koriath, please call Simon Targett, Sommerfield Communications, on +44 (0) 207 060 6551
This press release is provided for informational purposes only and is not intended to be investment advice. Any references to specific investments are for illustrative purposes only. The information herein does not constitute a personal recommendation or take into account the particular investment objectives, financial situations, or needs of individual clients. This release is not an offer to sell or the solicitation of an offer to buy any security in any jurisdiction. Past performance is not a guarantee of future returns.
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