DGF IS DEAD!

19 November 2018

Over the last 10 years, there has been a proliferation of Diversified Growth Fund (DGF) offerings and there is now an almost bewildering array to select from. In this article, we discuss how DGF should be considered in your portfolio, which will help gauge the success, or otherwise, of your investment manager.

The key points:

  • Think of DGF as an implementation approach, not an asset allocation decision
  • Understand what your DGF manager is trying to achieve, and the tools they will use to achieve those objectives
  • Make sure the objectives, particularly with reference to risk and return, are aligned with your own, and that they are realistic
  • Remain open to opportunities that your DGF manager either will not or cannot access, such as illiquid asset classes
  • Understand how your DGF manager expects to perform in different market conditions, and judge them on that basis
  • Ensure you are getting value for money!

WHAT IS DGF?

For the avoidance of doubt, DGF is not a distinct asset class in itself, it is an investment approach.  There is no universally agreed definition of what a DGF actually is. However, the two most common characteristics are as follows:

  • A return objective measured relative to cash or inflation (the most common one being cash + 4% p.a. over rolling periods) either way, it’s often reflective of what one would expect from equities over the long term;
  • A volatility objective measured relative to equities, with a target of half to two-thirds that of equities, although it should be noted that the definition of equities can also vary.

Another common characteristic is aiming to limit drawdowns based on the rationale that if a fund falls 50%, it needs to increase by 100% to get back into positive territory.  Therefore if drawdowns can be avoided or minimised, there is less damage done to longer term returns.

DIFFERENT TYPES OF DGF

The market for DGF really took off after the global financial crisis which began in 2008.  The funds that were launched prior to 2008 and successfully navigated the markets over this period tended to do extremely well, picking up significant assets under management along the way. These flows led to many managers launching new funds to participate in this movement towards DGF.

If we examine the universe of DGFs, they range from what are known as ‘traditional’ DGFs at one end of the scale to funds targeting ‘absolute’ returns (another overused term!) at the other.  

The traditional DGFs tend to hold 40%-60% in equities, 20%-40% in bonds and up to 30% in alternatives.  This asset mix may be managed on a fairly static basis or in some cases on a dynamic basis.

At the other end of the scale, the ‘absolute’ return DGFs are essentially managed as macro hedge funds, with both long and relative value positions held in equity markets, credit, currency and interest rates.  The attraction of these types of funds is that they can theoretically deliver positive returns in all market conditions.

In between, there are funds that combine elements of a traditional DGF with that of absolute return funds.  Many funds make extensive use of derivatives to implement asset allocation decisions and manage the downside. 
 
In short, many DGFs are significantly more complex than many investors are aware and this can cause problems when trying to understand why a particular fund has performed as it has.

HAVE THEY DELIVERED?

To judge DGF as a homogeneous group can be misleading given the wide range of approaches adopted.  For example, we would expect an absolute return style manager to outperform a traditional manager when equity markets have a correction, and vice versa.  Looking at returns alone requires caution.  Risk adjusted return analysis is better, but not perfect. The past few years have been unusually benign; and a good risk adjusted return might mask taking too little or too much risk.

Nonetheless, the table below explains why investors may be disappointed with their DGF managers.

 

1 year % p.a.

3 years % p.a.

5 years % p.a.

10 years % p.a.

Median DGF

2.4

3.4

4.8

5.0

Equities

9.9

15.6

13.7

11.3

Cash plus 4%

4.4

4.4

4.5

4.8

Source: JLT’s Multi-Asset Manager Analysis to 30 June 2018; manager performance net of fees.

Whilst it would be unrealistic to expect a return in line with equity markets, the average DGF has not managed to deliver anywhere near equity returns over all the periods shown.
 
Has something gone wrong?  There are a number of factors:

  • The equity returns quoted above are on an unhedged basis whereas most DGFs manage to sterling benchmarks, often hedging out a large proportion of overseas currency risk which would otherwise have boosted returns.
  • Many DGFs have been concerned about a setback in equity markets.  Lower exposure to equities and/or hedging strategies has reduced returns. 
  • Relative value strategies have struggled over the last three years in particular.  One possible explanation is the actions of central banks injecting liquidity into the financial system, by keeping interest rates low and quantitative easing, has taken some markets away from fundamentals.  

So, have managers taken their sterling benchmarks too literally?  Have managers been too focussed on capital protection?  Should investors be wary of strategies relying on alpha (i.e. absolute return) rather than market exposure?  The answer to these questions will vary depending on what the DGF manager has stated they will do.  However, in some cases there is cause for legitimate discontent.

SHOULD DGF CONTINUE TO MAKE UP PART OF YOUR INVESTMENT STRATEGY?

Before answering this question, let’s look at some of the reasons why so many investors have allocated to DGF.

  • Achieves diversification without the time and governance of appointing lots of managers
  • Access to real time tactical asset allocation
  • Access to “large investor” strategies by benefiting from a fund’s scale

Given the above, DGF continues to be appropriate for many investors.  However, a careful review of your existing or any prospective managers should be undertaken in line with a review of your objectives.  The following framework should be considered.

  • What returns do I really need and what underlying market allocation can achieve this return?  Can I tolerate the implied level of risk?  If not, rethink your return expectations.
  • If DGF is considered as an implementing option, be realistic about the contribution from tactical asset allocation. If diversification is your main aim, this may be accessible more cheaply using direct allocations or by using an investment platform.
  • Be clear on what your DGF manager will do in terms of asset allocation and measure them on that basis.  Are you comfortable with large changes in asset allocation being at the manager’s discretion?  Don’t rely solely on “alpha” strategies for all of your return requirements. 
  • If your DGF manager is using complex techniques, e.g. relative value or equity hedging strategies, ensure they have the necessary experience and capability and that you have a reasonable understanding of the positions that they implement.
  • Consider whether additional allocations to asset classes are required to meet your target level of risk and return.  Understand there are strategies you can benefit from that DGF may not use; in particular you may have more tolerance for illiquid asset classes than a fund that needs to trade every day.  

So, we don’t think DGF is dead and it can be a low governance way to achieve diversification.  However, its role and size in your portfolios should be clearly understood and, for many investors, is probably due a review.

For more information, please contact Bernard Nelson | +44 (0) 113 203 5806 | bernard_nelson@jltgroup.com