An interview with Neil Morgan, Senior Pension Trustee, Capita Asset Services - part of the Diversified Growth & Multi-Asset Funds 2016 Report

Zara Amer, Head of Content, Clear Path Analysis: Would you say that DGFs are well understood in the industry? Are Trustees and Scheme managers clear about what they can deliver?

Neil: I think that in general they are pretty well understood, generally being sold with the mantra ‘equity like returns with half to two thirds of the volatility of equities’. Of course there are a number of different varieties of DGFs, and the ones that are ‘hedge fund–lite’ are the ones that are perhaps more difficult for trustees to get a handle on.

Deciding whether a DGF is right for a scheme, and what type, will involve trustees looking at their ‘journey plan’ and investment objectives. With the usual requirement of trying to make good a deficit, without taking too much risk - DGFs will tick that box.

In general, they have delivered on the lower risk aspect, while returns have been more diverse. Of course trustees can’t really have their cake and eat it, so downside protection in down equity markets comes at the cost of lower returns in rising equity markets.

However there have been murmurings of discontent recently, based on relatively poor performance (relative to rising equity markets), and so some questioning of the ‘value for money’ provided by DGFs – achieving cash, plus a bit more isn’t a great deal at present, and after fees may not be contributing towards deficit reduction.

It’s sometimes been the case that trustees have approached risk reduction through reducing a scheme’s exposure to traditional (market cap-based) equities, and then investing in a DGF, rather than reducing interest rate risk through, for example, LDI funds or just bonds. So while the liabilities of such schemes will have increased significantly of late, the asset side of schemes with DGFs will have been treading water.

Zara: Can you talk to us about the next generation of DGFs and how you see them evolving? How do you see the market developing over the coming year?

Neil: As with smart beta, there is product proliferation in DGFs, so the need to differentiate has become more important. One area of development will be in looking to incorporate illiquid asset categories, other than through listed equities.

However, with the current requirement for daily pricing and daily dealing in defined contribution (DC) arrangements, where DGFs are used a lot, this is a significant challenge. In addition, the charge cap in DC, limits the use of asset classes and strategies which are more costly to implement.

Another area will be the incorporation of smart beta within DGFs – that is, in the equity space, non-market cap-based weighted equity funds that provide exposure to well known ‘factors’ such as value, that have outperformed over the long term.

Of course, some schemes may have an exposure to both a DGF and to smart beta, and indeed they can be complementary. But dampening down overall growth asset volatility through, for example, a low volatility smart beta product may produce better risk adjusted returns over the longer term than by investing in a DGF (and will usually be cheaper).

Zara: How can DGFs help pension funds? More specifically, how helpful have they been for DC investors?

Neil: For Defined Benefit (DB) schemes, it depends on the pension scheme’s objectives and risk appetite – so what expected return do you need to get to being fully funded in say 10 years? – and then look at the risk of that in relation to the sponsor covenant. If risk has to be dialled down, then investing in a DGF with an absolute return focus can be one way of achieving this – but also another way would be investing in a smart beta fund with a low volatility, relative return, focus.

For larger schemes, they would tend to build their own DGF in-house, and use a much broader range of asset classes and strategies, such as direct property and hedge funds

In DC, DGFs have been widely used in default funds to meet the needs of what is usually a broad membership. In the accumulation phase of a default fund they are seen as providing reasonable growth but with reduced volatility (compared to equities). However with the charge cap, passive equities will usually be blended in to the default fund as well, in order to reduce costs.

So a DGF will be helpful in times when equities are falling, but will likely hold back ‘pot sizes’ in periods when equities are rising. However if trustees feel that there may be a danger of members ‘opting out’ as a response to equity volatility, then DGFs are likely to serve a useful purpose, ensuring member contributions are maintained throughout scheme membership.

Again, there is a trade-off however, in that if DC members generally had perhaps a better understanding of investment risk at the start of their savings journey, then they would likely be prepared to have more (and cheaper) equity exposure. The lesson here is that communication to members about risk needs to be better, enabling them to become more comfortable with equity volatility, so leading to better outcomes for members at retirement.

Zara: What do you see as being the main challenges affecting the DGF market?

Neil: Probably those of diversification, and of active management. On diversification, while a DGF may state that it has an exposure to infrastructure or property this is usually via listed equities rather than investing directly in bricks and mortar for example. So when equity markets fall, these investments are also likely to fall and they therefore offer less diversification than investing directly in illiquid asset classes. So ‘better’ diversification should be the aim but at present this is a challenge, as noted above

Also, there is the age-old question of the merits of active management. A number of DGFs are actively managed either within assets classes or between them or both.

Certainly in DC, the equity allocation of a DGF within a default fund will invariably be passively managed, and indeed within DGFs in DB schemes, smart beta allocations are beginning to replace actively managed equity portfolios, recognising that for example a value tilt can be achieved far more cheaply in this manner.

And then there is the question of whether value can be added through dynamic, or tactical, asset allocation – so for example, hopefully moving into cash as the equity market falls. The evidence is mixed at best here. Valuations of asset classes matter – but over the medium to longer term, and so shorter term tactical moves can often detract value, and DGFs that offer tactical asset allocation are usually more expensive.

Zara: In your opinion, do DGF strategies differ enough from one another?

Neil: There has been a proliferation of DGFs and so with asset managers looking for ‘an edge’, inevitably the market has become fairly well differentiated – from old-style balanced funds to hedge fund-lite. So some managers are focused on a fairly passive strategic asset allocation to asset classes, some are tactically switching between them, while others are pursuing relative value trades such as, for example, the US dollar against the Canadian dollar, implemented through FX forward contracts.

Put another way, some DGFs are more ‘risk premium’ based – benefitting from a static investment in equities for example - while others – the hedge fund-lite funds – rely more on manager skill to add value.

So trustees have a lot of choice when investing in a DGF, and they will doubtless evolve further. Hence selecting the right DGF manager is very important, being based on the scheme’s objective and risk capacity for a DB scheme, and on broad characteristics of the membership for a DC scheme.

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