Mark Parry explains the benefits of diversified growth funds for both DB and DC pension schemes

Diversified growth funds (DGFs) are growing in popularity. The broadness of their appeal means that they are competing for a large portion of pension scheme assets.

They offer an easy-to-understand alternative to equities and aim to smooth out returns, providing clear attractions for defined benefit schemes. Many also see them as a perfect fit for defined contribution default lifestyle strategies.

The increase in appetite for DGFs reflects a wider trend toward less volatile returns. Despite being nearly four years ago, the market chaos caused by the collapse of Lehman Brothers looms large in investors’ minds. The trend towards DGFs also reflects a broader failing of what are known as traditional balanced managed funds. The limitations of a simple bond/equity approach, coupled with an inherent structural bias towards developed market assets are now becoming
clear. Traditional balanced funds typically focused on short-term performance and peer group comparison rather than meeting the long-term objectives of the underlying investors. They have also tended towards high equity exposure and relatively static asset allocations, creating unnecessary volatility.

Contrastingly, DGFs are truly flexible multi-asset funds. They typically invest in a diversified range of asset classes, looking to generate equity-like returns with lower volatility, often with performance benchmarks linked to inflation. They have no restrictions over specific asset weightings (such as a set percentage in equities) and, in extreme market conditions, can reduce equity exposure down to zero. These vehicles invest in many of the same asset classes as traditional balanced portfolios but the key difference is that the allocation to different markets and asset classes are better spread, and allocation shifts are much more dynamic in nature.

By breaking away from peer group based benchmarks and focusing more on absolute benchmarks, such as a set return over and above cash or inflation, diversified growth funds are able to be genuinely dynamic in nature when compared to traditional balanced products. Portfolios are freed from the shackles of benchmark restrictions, be they by explicit asset allocation limits or more subtle peer group pressure. This extra flexibility increases the potential for better risk-adjusted returns as assets can be shifted to suit market conditions. This does not mean that negative returns are always avoided, but the expected muted variability of return lends itself well to pension investing. Defined contribution members should not suffer unduly from unfortunate disinvestment timing and variations in defined benefit balance sheet valuations should be
less extreme.

In line with the desire to lower volatility has been a lower allocation to equity markets in general, with a higher component in bonds and alternative asset classes such as commodities, infrastructure and property. There has also been a desire to adopt a more global perspective. This has already been happening to a degree within the standard balanced approach, but a gravitational pull towards developed markets has also resulted in domestic asset classes dominating allocations. Such an allocation pull has often been guided by the size of the opportunity set (e.g. market capitalisation), or indeed the relative ease with which positions could be hedged (e.g. the existence of liquid futures markets) rather than where the best investment opportunities lie. The result has been a tendency for many products to have the bulk of their exposure in the developed world. Consensus forecasts, however, suggest that the developed world is undergoing a sustained period of subdued growth, bringing into question the growth prospects of such less dynamic strategies.

Our approach to diversified growth investing is different to many others. Whilst we incorporate the dynamism afforded by a more flexible mandate, we also ensure that the developed market bias prevalent in so many portfolios is removed. The importance of emerging and developing nations over decades to come cannot, and should not, be overstated. As familiarity with emerging markets grows, so will allocations from developed market investors. In turn, liquidity will improve and their ‘risky’ perception will further wane. The story is simply not going away.

Strategically weighting portfolios over the long term to reflect this trend makes a great deal of sense. The flexibility of DGFs makes them a perfect vehicle to capture the potential gains from such an approach.

Written by Mark Parry, senior investment manager, Aberdeen Asset Management

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