The coronavirus outbreak has triggered exceptional fiscal responses from governments worldwide, injections of liquidity from central banks and a relaxation of some regulatory rule sets.
But despite all measures, fear continues to grip markets. The CBOE Volatility Index – or VIX – is commonly referred to as the ‘fear index’, acting as a bellwether for investor nervousness. At the start of 2020, the VIX stood at 13.46. Following the events of March 12, it closed at 75.47. The last time investors were this nervous was in the throes of the financial crisis in November 2008.
Unsurprisingly, investment portfolios have also taken a hit, with major stock market indices including the FTSE100, DAX, Nikkei 225, S&P 500, CAC40, all losing more or less a third of their value in March 2020. So, is this the moment when those DC schemes that invested a larger proportion of their portfolios in Diversified Growth Funds, finally feel vindicated? Well, it isn’t quite that simple…
Over the past decade, investors have seen just how wildly different these funds can behave. For e xample, mast er trust Now:Pensions found itself the subject of severe scrutiny over its risk parity derivative based strategy, which permits 200 per cent leverage and holds synthetic risk premia, as opposed to physical assets. Data from Corporate Adviser’s Capa-Data service shows the master trust has significantly lagged its peers for much of the past seven years.
But Now:Pensions is not alone in opting for a DGF that has disappointed. Many investors have become frustrated with DGFs in recent years, as the gap between their performance, and that of the global blistering stock market, widened.
“They began to significantly lag equities as markets continued to rally during the 2013-2015 period,” explains Isio investment consultant and head of multi-asset research Neil Otty.
“Over this period, some markets began to look expensive relative to history, leading to managers reducing risk,” he said. “From mid-2016, markets rebounded sharply, and the cautious positioning meant the majority of DGFs, in a sample of 15 that we looked at, did not participate in the market recovery to any great extent.”
This lack of performance in the good times certainly tarnished the image of DGFs. But consultants say it’s important to distinguish between different DGF types. Like the aforementioned Now:Pensions example, some approaches can be radically different.
“Some DGFs have done a fairly convincing job of proving themselves to be entirely unsuitable for any investor,” says XPS chief investment officer Simeon Willis stressing that it was important not to talk too generally. “There are fund types ranging from those with a hedge fund-like absolute return target in all weathers, to those providing relatively static diversified exposure to passive indices,” said Willis. “The key is comparing fund performance against their stated aim.”
Time to review
The one thing the coronavirus outbreak has done is encourage asset owners to pay closer attention to their portfolio positioning. For corporate advisers, the challenge now will be helping clients to assess whether DGFs will perform better in the coming decade than they did over the past ten years – or continue to disappoint.
To assess this, it makes sense to return to the original intention of DGFs. When they first appeared, they were marketed as investing in a broad set of assets, with a view to making stable returns over inflation for three or five years, perhaps longer. Providers promised “equity-like” returns but with lower volatility.
“Another way of looking at DGFs is that they are de-risking solutions designed to lower volatility whilst retaining growth upside,” explains, Aon partner Vicky Kydoniefs.
“They try and dynamically adjust allocations between growth and defensive assets, which hopefully leads to better outcomes at the end of a market cycle.”
Given that recent market volatility has been at its highest level for 12 years and equity indices have retreated considerably from their peaks, is now the time to look at DGFs once more? Some consultants think it is.
“During the Global Financial Crisis of 2008, DGF approaches suffered less than equities and regained their losses more quickly than equities,” says Kydoniefs.
“Other periods of market stress have seen a similar pattern of results, and for this reason, we expect that DGFs will achieve their objective for reducing capital losses caused by macro-economic influences such as the current coronavirus.”
However, Kydoniefs stresses that DGFs are still exposed to risk assets and as such will suffer losses when markets plummet.
“However, as expected from a lower risk solution, the drawdown that these funds experience in volatile market conditions should be less than equity markets. This may make DGFs look more attractive,” she concludes.
Willis says the market headwinds relating to coronavirus will still mean that most funds struggle for good performance. However, he says that the more defensive strategies should be better at limiting the magnitude of these losses.
“Any fund that expects to perform strongly off the back of short-selling should be approached with caution for long-term mainstream investment,” he says. “However, in the main, we expect equity and other growth assets to reward investors for taking market risk, so we would expect the markets to earn a risk premium in the long term.”
Corporate advisers who are weighing up the appeal of DGFs in the current climate should begin by researching the risk and return profile of the fund and make a judgement call as to whether that matches the strategy of the client. They also need to consider whether the funds deliver good “value”.
State Street Global Advisors head of pensions and retirement strategy Alistair Byrne says intermediaries should evaluate the extent to which each fund can be expected to participate in the upside of equity markets and to what extent they can be expected to provide protection on the downside.
“How does the allocation to the DGF fit with the member’s ability to take risk?” he asks. “For example, less DGF when the member is younger, but higher allocations as the member gets close to retirement and needs more protection for their pot.”
Byrne also underscores the importance of researching the management team of each fund and making sure that it is possible to clearly understand their investment process and fee structure.
Yet, not everyone agrees that DGFs will appeal. Among them is Isio’s Otty who says the strategic reliance on DGFs is likely to reduce, with greater focus instead being placed on individual asset classes and opportunities that offer greater “certainty” of achieving performance targets.
With this in mind, Otty says that corporate advisers should consider a range of factors, including liquidity, costs and short- term underperformance in their initial assessments.
But as Otty points out, there are other fundamental aspects to consider, too.
“We believe investors should con s ider th e ris k / re turn characteristics,” says Otty. “Is an allocation to a DGF optimal and could the return be achieved by investing in asset classes producing more certain outcomes through credit or private markets, for example?”
Essentially, investors should determine if the DGF they invest in provides value for money in terms of the manager skill they are paying for, which, especially for DC investors, may take up a large proportion of the charge cap.
BOX: DGF defaults through the downturn
Indicative figures supplied by a small selection of providers illustrate the way negative markets hit aggressive funds more than DGFs with built-in safety features. Growth phase investors in LifeSight saw a 23 per cent 12 month return to the end of 2019 turned into a -2.6 per cent return in the 12 months to 10.3.20, after the first big fall of the coronavirus crash. Now: Pensions, which delivered growth phase investors a less exciting 15.96 per cent across 2019, and which has adopted a more cautious strategy than most other providers, experienced a return of 5.24 in the 12 months to 11.3.20.
Has the DGF’s time finally come?