Most pension schemes see diversified growth funds (DGFs) as a core allocation, valuing the consistent growth they offer while their diversification is designed to protect against falling markets.
Most pension schemes see diversified growth funds (DGFs) as a core allocation, valuing the consistent growth they offer while their diversification is designed to protect against falling markets. However, our analysis suggests that many DGFs are not truly diversified and are far more correlated to equity and bond markets than many investors suspect. This correlation may have supported impressive recent performance but risks a substantial sell-off when markets fall. Moreover, if DGF strategies are not sufficiently diversified, investors might be better off buying an index and saving on management fees.
Brexit turmoil challenged many DGFs
The post-Brexit vote turmoil allowed us to test whether DGFs actually protect against a market sell-off. Since there isn’t a strict definition of DGFs, we looked at funds available in the UK with a sterling share class, and which are commonly labelled as DGFs. We excluded balanced and multi-manager funds, which left 27 funds that we considered a fair representation of the DGF market.
Nearly all the DGFs in the population suffered declines immediately following the Brexit vote1, performing poorly in exactly the volatile markets they were designed to protect against. Of the 27 funds, 25 experienced drawdowns – of more than 6% in the worst case – in the five days following the referendum, with the average drawdown being 1.6%.
Not all DGFs are the same
We believe that a rigorous evaluation of DGFs should assess not just performance but also funds’ diversification. We felt it useful to subdivide DGFs into ‘traditional’ (predominantly long-only) and ‘alternative’ (deploying a wider range of strategies) categories; consistent with how consultants often view the market.
We believe that a truly diversified fund can protect against losses during periods of volatility
We found that traditional DGF returns have predominantly been driven by equities and bonds2. More than 72% of the volatility can be explained by these two asset classes, compared with 37% for alternative DGFs.
DGF returns and diversification
There is no perfect benchmark against which to evaluate DGF returns, and we took a simple blended index comprising 60% global equities and 40% gilts.
Our research suggests that:
• Alternative DGFs outperformed traditional counterparts and demonstrated far lower volatility
• The performance of most traditional DGFs has predominantly been driven by equities and bonds
• Alternative DGFs experienced far shallower losses than traditional funds
• Alternative DGFs seem to offer far greater diversification, which we believe makes them more resilient against market stress
• No single DGF offers the complete package. We favour blending at least two alternative DGFs to achieve diversified growth with downside protection
Protecting against volatile markets
In an environment of low market returns, many DGFs risk underperforming their benchmarks and may suffer significant capital losses in volatile markets. Yet, alternative DGFs can provide an attractive complement to existing portfolios. Our analysis identified the following characteristics of funds that best protected capital during the Brexit volatility:
• Low correlations to equities and bonds
• Employing both fundamental and systematic methods
• Employing both active and passive components to reduce costs and increase alpha potential
• Balancing risk across the portfolio
• Generating smoother returns by managing the portfolio to a volatility target
We found that surprisingly few DGFs were able to exhibit many of these characteristics, suggesting that the choice available to investors remains limited just when they might be needed most.
A different approach to diversified growth
We believe that a truly diversified fund can protect against losses during periods of volatility. For example, portfolios could be allocated not along traditional asset class lines but across broad, independent categories, such as market exposures, manager alpha and alternative strategies. The market exposures allocation could look to capture broad market movements while the manager alpha allocation would reflect pure stock selection; with the manager seeking to hedge out the broader market exposure. The alternative strategies allocation could look to capture inefficiencies in markets, for example arising from relative value opportunities or market momentum. This diversification strategy successfully protected against downturns in the aftermath of the Brexit vote, and produced positive returns over that period.
Disclosure: This material and/or its contents are current at the time of writing and may not be reproduced or distributed in whole or in part, for any purpose, without the express written consent of Wellington Management. This material is not intended to constitute investment advice or an offer to sell, or the solicitation of an offer to purchase shares or other securities. Investors should always obtain and read an up-to-date investment services description or prospectus before deciding whether to appoint an investment manager or to invest in a fund. Any views expressed herein are those of the author(s), are based on available information, and are subject to change without notice. Individual portfolio management teams may hold different views and may make different investment decisions for different clients.
1 Sources: Bloomberg, Wellington Management, June 2016
2 Sources: Bloomberg, Wellington Management, April 2008 - August 2016
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