Diversified growth funds: What to do when they don t deliver

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1 Diversified growth funds: What to do when they don t deliver Matthew Bullock Investment Director, Global Multi- Asset Strategies Matthew is responsible for a range of investment approaches and custom solutions for our clients in Europe, the Middle East and Africa. He helps to ensure the integrity of our investment approaches by overseeing portfolio positioning and performance and risk exposures, as well as by conducting analysis to inform their investment processes. Ben Cooper, CFA Multi-Asset Analyst As a multi-asset analyst in Global Multi-Asset Strategies, Ben researches long-term multi-asset themes in order to assist clients with strategy and policy issues. His work also includes research on historical capital market performance and the maintenance of quantitative models and databases to support multi-asset research. Diversified growth funds aim to protect against downside risk, but mostly performed poorly during recent market volatility. Diversified growth funds (DGFs) are a fast-expanding segment of the UK institutional market. Much of their recent rapid growth has been driven by an attractive sales pitch offering consistent returns with substantially lower risk through diversification. However, the poor performance of many DGFs during recent market turbulence questions their ability to protect against downside risk, with some funds suffering significant drawdowns when markets fell. Where does that leave investors? Key points Many traditional DGFs are not that diversified and track equity and bond indexes more than investors suspect, which risks substantial drawdowns in volatile markets (e.g., following the Brexit vote). Not all DGFs are the same: in our view so-called alternative DGFs have a better chance of delivering their stated goal of consistent long-term growth with significantly reduced volatility. We believe investors should reassess their DGF holdings. With no single fund offering the complete package, we favour blending at least two alternative DGFs to achieve the desired overall outcome. DGFs have accumulated assets under management (AUM) of more than 124 billion, and are expected to exceed 200 billion by Though tracing its origins back to the early 2000s, the sector blossomed after 2008 as UK definedbenefit (DB) pension funds, facing heavy funding deficits caused by the financial crisis, sought solutions that aimed to generate long-term consistent growth without the associated risks. Now, amid a re-emergence of volatility and concerns that global growth may be slowing, DGFs could be due another period of supercharged asset growth. Nearly every pension scheme currently sees DGFs as a core allocation, and for good reason. The combination of a growth objective and a focus on risk management makes DGFs a sensible starting point. However, we are concerned that the DGF label has distracted investors attention from their original objective. Our research shows that most DGFs maintain high levels of equity beta, and performance has been flattered by strong equity and fixed income markets since the financial crisis. Our worry is that investors might assume that a DGF will continue to deliver on its objectives, just because it has largely done so over the past five years. However, as we show below, many have performed poorly in the sorts of volatile markets they were supposedly designed to protect against.

2 2 In fact, most DGFs are little more than simple balanced funds with a few bells and whistles, and yet they charge active fees. With certain exceptions, which we will come to later, many funds have delivered less than a portfolio combining passive exposures to equities and bonds. A common rebuttal to this charge is that, while returns may not always match a passive equity and bond exposure, DGFs offer that all-important element of risk management. Unfortunately, the data does not support this notion: the reduction in risk is in many cases immaterial (see below), and many DGFs failed to protect investors against recent market volatility. The market typically assesses a DGF s performance against its stated objective and historical level of volatility. In our view, however, this approach does not properly evaluate the manager s skill and may exaggerate the appeal of most DGFs, which have only existed against a backdrop of strong returns from equities and bonds, with market volatility at extreme lows. We would argue that a rigorous evaluation of any DGF should include an assessment of its diversification. That is a much harder task and the main goal of this paper. Unfortunately, we find that most DGFs are not diversified and their portfolios are not adequately structured to generate long-term growth. Why have DGFs grabbed so much market share so quickly? The growth of the DGF sector should be little surprise given the sales pitch: DGFs aim to generate similar returns to equities with substantially lower risk, sometimes only half that of equities. This simple message resonates well with investors. Most seek to achieve this twin objective by combining asset allocation decisions and downside risk management. However, both require significant skill from the portfolio management team, notably an ability to time the market successfully. DB schemes are a natural fit for this type of investment approach as they are vulnerable to any sudden shocks in market returns: any deficit caused by declines needs to be filled by the scheme s sponsor (in many cases, the employer). In 2008, it became clear just how significant such a shock to DB scheme funding levels could be (Figure 1). Figure 1 UK DB schemes remain chronically underfunded Historical aggregate balance and funding ratio for schemes in PPF universe billion Aggregate balance (LHS) Funding level (RHS) Funding level (%) /06 8/07 8/08 8/09 8/10 8/11 8/12 8/13 8/14 8/15 8/16 As at 31 January 2016 Source: Pension Protection Fund (PPF)

3 3 In the UK alone, DB schemes funding levels went from over 100% funded in mid-2008 to 20% underfunded barely six months later. Today s level of funding remains very similar, even after five years of strong returns for equities and fixed income. To put this in context, over 4,751 DB schemes in the UK (nearly 80% of all UK DB schemes) are in deficit, totalling approximately 460 billion. This gap has to be filled somehow. DGFs have been seen as one of the key ways for pension schemes to chart a path back to full funding while avoiding some of the market uncertainty. But can they realistically achieve that? Our study In this loosely defined sector, the first step was to review and categorise DGFs. While there is no strict definition of a DGF, we looked at funds available in the UK which offer a sterling share class and are commonly labelled as DGFs. We excluded balanced funds and multi-manager funds. The result was a list of 27 funds that we thought were a fair representation of the DGF market. Consultants and the media generally subdivide DGFs into two categories: traditional and alternative 1. In order to adopt this approach in a transparent and rule-based manner, we categorise each fund according to its two-year rolling equity beta. Funds with an equity beta of greater than 0.3 are classified as traditional DGFs, the rest as alternative DGFs. While this approach means that funds can move between the two categories, we found that this happens only rarely. Based on these criteria, the funds were fairly evenly split between traditional and alternative DGFs. With this process in place, the study aimed to: Assess the performance of the DGF market Understand DGFs sources of returns Consider their portfolio construction and diversification Produce tangible recommendations for constructing a diversified portfolio Our findings In summary, we conclude that: Most traditional DGFs are not compelling diversifiers and do not offer value for money. Most traditional DGFs have clearly benefited from the strong equity and bond returns of recent years. What has not been so evident is that they are also exposed to the risks associated with these two asset classes. Risk management for traditional DGFs has reduced volatility but, from our perspective, not enough to justify the cost and the adverse impact on upside capture. 1 While there is no industry-wide definition, we see traditional DGFs as predominantly long-only strategies with the capacity to hold short positions opportunistically. Alternative DGFs adopt a number of the approaches of traditional DGFs but have a greater emphasis on generating returns in a wider variety of ways, including using relative-value, shorting and absolute-return strategies. In our view, no single alternative DGF offers the complete package. We advocate using a blend of at least two alternative DGFs in order to achieve the desired growth outcome.

4 4 Assessing DGFs returns There is no perfect benchmark for comparison with DGF returns. However, we believe a simple blended index of 60% global equities and 40% gilts makes a good starting point (Figure 2). Figure 2 Traditional DGFs have underperformed an equity/gilt blend and alternative DGFs Cumulative returns for DGFs (January 2008 August 2016) /40 Traditional DGFs Alternative DGFs /07 8/08 3/09 10/09 6/10 1/11 8/11 4/12 11/12 7/13 2/14 9/14 5/15 12/15 7/16 We found that traditional DGFs displayed a similar risk profile to the 60/40 index but delivered a meaningfully lower annualised return. In contrast, alternative DGFs displayed significantly lower risk and offered a comparable annualised return. It would be unfair to conclude from this that the 60/40 index is a better investment than traditional DGFs. The past few years have been a period of strong returns for both equities and bonds, and a risk managed diversified fund should be expected to lag on performance in such an environment. However, the risk characteristics of the sector should not be skewed by market performance. And, as Figure 3 shows, it is here that the case for traditional DGFs which is based as much on risk management as on returns starts to look weak. Figure 3 Alternative DGFs have provided much lower volatility than traditional funds DGF characteristics, January 2008 August /40 Index Traditional DGFs Alternative DGFs Annualised return 5.7% 4.3% 5.4% Annualised risk 9.9% 9.0% 5.5% Correlation to 60/40 index Largest drawdown -30% -24% -8% As at 31 August 2016

5 5 Lastly, we assessed the drawdown or maximum loss experienced by investors from the top of the performance cycle to the bottom (Figure 4). We expected this to show a benefit from active diversification, compared with investing in a passive 60/40 index. Figure 4 Alternative DGFs have experienced shallower drawdowns than traditional DGFs % /40 Traditional DGFs Alternative DGFs /07 6/08 12/08 6/09 12/09 6/10 12/10 6/11 12/11 6/12 12/12 6/13 12/13 6/14 12/14 6/15 12/15 6/16 In fact, we found that the drawdowns experienced by traditional DGFs have been comparable to, and often exceeded, those of the index. By comparison, alternative DGFs had far shallower drawdowns which is, after all, the whole reason for the existence of the DGF sector. Measuring diversification We advocate alternative DGFs based on the conviction that they offer much greater diversification and are better designed for the periods of market stress when they are needed most. If strategies are not sufficiently diversified, investors would be better off buying an index and thus reducing management fees. To test this conclusion, we ran regressions of DGF returns against equities and gilts to determine the volatility of returns relative to the market as a whole (beta). This analysis found that traditional DGF returns have been predominantly driven by equities and, to a lesser extent, bonds, as shown by the betas in Figure 5. Over 72% of the volatility can be explained by these two asset classes, as compared with 37% for alternative DGFs. Figure 5 DGFs beta to equities and government bonds April 2008 to Aug 2016 Beta to equities Beta to gilts Traditional DGFs Alternative DGFs

6 6 Many DGFs failed the Brexit test One of the key selling points of DGFs has been that their diversification provides investors with capital protection during periods of severe market turbulence (this is to a large extent what managers are paid to do). However, our analysis casts doubts over this claim. We ve found that many DGFs aren t truly diversified and are far more correlated to market movements than investors might suspect. This risks substantial losses in periods of volatility. The turmoil following the Brexit referendum provided an opportunity to put our thesis to the test: to gauge whether DGFs actually provide the diversification to protect against a market sell-off. A review of the sector s performance shows that nearly all DGFs suffered declines immediately following the Brexit vote. Of 27 DGFs available to UK investors, which include the Wellington Multi-Asset Absolute Return Fund (MAAR), 25 experienced drawdowns more than 6% in the worst case in the five days following the referendum, with the average maximum loss being 1.6% (Figure 6). T8 A16 A15 A14 A13 A12 A11 A9 A10 A8 T7 A7 A6 A5 A4 T6 T5 T4 T3 T2 A3 T1 A2 0 T11 T10 T9 Figure 6 MAAR -2 Maximum loss (%) Alternative DGFs (A1, A2, etc.) Traditional DGFs (T1, T2, etc.) Moreover, the speed with which most DGFs recovered their losses as the market rebounded underlined how many simply mimic the behaviour of equities and bonds. This questions the diversification and downside protection such funds can offer, and serves as a warning for the future: DGFs are likely to be tested even more severely in a more prolonged period of volatility. PAST RESULTS ARE NOT NECESSARILY INDICATIVE OF FUTURE RESULTS AND AN INVESTMENT CAN LOSE VALUE. Narrowing the results down to individual funds with AUM over 1 billion and a track record of more than three years, we find that the vast majority of those raising assets provide nothing more than a traditional balanced fund with downside risk management, which is likely to work only until equities fall. Figure 7 shows the betas to equities of the 10 largest DGFs (anonymised), along with the aggregate figures for traditional and alternative DGFs.

7 7 Our approach to diversified growth At Wellington Management, we have been running multi-strategy portfolios since 1928, and have built our capabilities organically through attracting and developing investors with the talent and inclination to manage assets in non-traditional ways. We ve been researching the DGF market for some time and in 2012 we launched the Wellington Multi-Asset Absolute Return Fund. We designed the fund to address many of the issues raised in this paper, and MAAR now manages over US$150 million (as of 31 August 2016). The fund seeks to generate absolute returns and systematically manage downside risk by investing across a broad range of asset classes and regions. Specifically, we believe our proven approach to asset allocation helps provide true diversification, which mitigates against volatility-driven drawdowns. Instead of considering portfolio allocation in terms of traditional asset classes such as equities, bonds and alternatives, we allocate across three broad and independent categories: Market Exposures, Manager Alpha and Alternative Strategies. The Market Exposures allocation looks to capture market movements whereas the Manager Alpha allocation reflects pure stock selection, with us seeking to hedge out the broader market exposure. Our Alternative Strategies allocation looks to capture inefficiencies in markets, for example, arising from the relative value of one asset/market to another or momentum driving markets higher or lower. This diversification strategy not only successfully protected against downturns in the aftermath of the Brexit vote, but produced positive returns over the period. Figure 7 DGFs over 1 billion Category Fund 1 Traditional 0.44 Fund 2 Alternative 0.25 Fund 3 Alternative 0.26 Fund 4 Alternative 0.23 Fund 5 Traditional 0.35 Fund 6 Alternative 0.13 Fund 7 Alternative 0.06 Fund 8 Traditional 0.33 Fund 9 Alternative 0.28 Fund 10 Alternative 0.25 Traditional DGFs in aggregate 0.39 Alternative DGFs in aggregate 0.20 Beta to equities (2 years to 31 August 2016) As we appear to be entering an environment of low market returns and heightened volatility, we would expect that a large proportion of the DGF market (third-party studies have suggested that over 70% of funds in the market are traditional) will underperform their benchmarks and may suffer significant capital drawdowns. What should pension plan trustees do? Investing in an alternative DGF makes sense and would in many cases complement an existing portfolio. However, our analysis of the DGF market has identified the following key criteria which pension trustees may want to look for when assessing products: Significantly reduced reliance on beta for generating returns Accurate assessment and monitoring of the correlation between equities and bonds, to understand the true level of diversification The use of both fundamental and systematic methods, as their performance can be very different depending on the market environment Employing both active and passive components, to lower costs and increase alpha potential A balanced risk approach across a complete portfolio, as accurately timing the market cannot be guaranteed Managing a portfolio to a volatility target using appropriate signals, in order to generate smoother returns after all, market volatility is constantly changing Surprisingly few of the DGFs in our study were able to exhibit many of these characteristics. While some of the newer funds fall under our definition of alternative DGFs, the choice available to investors remains limited just at a time when they might be needed most.

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