In this blog, Phil Boyle comments on a recent article in the Financial Times on diversified growth funds (DGFs).
A recent article in the Financial Times reported that fees charged by Diversified Growth Funds (“DGFs”) are “too high and not commensurate with their skill” and that “investors can generate similar returns much more cheaply using a simple passive portfolio of 60% equities and 40% bonds”.
This is an important issue as UK pension fund money has been shifting from equities into DGFs over the last decade as part of a general de-risking through diversification trend. Diversification – the only free lunch in investment – can be achieved either by delegating the task to a DGF investment manager or by working with your investment consultant to build a portfolio of a broad mix of assets.
Smaller pension funds have tended to prefer the off-the-shelf diversification that DGFs provide, but bigger schemes have bought into DGFs too, in the belief that managers have skill in allocating dynamically between asset classes.
We have long believed that for many pension funds the DGF route is a great way to diversify; the claims that DGF managers typically lack skill and that their exposures can be replicated by a simple passive portfolio are claims that we have been testing for years as part of our own in-house research process.
What our research reveals:
First, let’s consider the claim that “investors can generate similar returns much more cheaply using a simple passive portfolio of 60% equities and 40% bonds”.
We regularly use a mathematical technique called “regression” to look at how much of each DGF manager’s returns (after fees) can be explained by passive allocations to equities and bonds. Interestingly, on average about 40% of the returns can be explained by equity investment.
It’s reassuring that this is relatively low since one of the main benefits DGFs are meant to provide is diversification away from equities. On average, around 30% can be explained by a passive allocation to bonds. That leaves approximately 30% of the returns that must be explained some other way. And these are the average figures; for some DGF managers these proportions are much lower.
For scheme trustees that buy DGFs simply because they want straightforward ready-made diversification the fact that the returns CANNOT be explained by passive weights to equities and bonds is a VERY important conclusion, because it’s telling you that you’ve achieved your goal: diversification – returns that are fundamentally different in nature to those provided by the conventional asset classes.
But what makes up the “missing” 30%? A few things could explain it. For example, the manager may be investing in other things (eg property, commodities or other alternative investments), or the manager may be skilfully (or luckily!) allocating between assets.
The answer to this question is important since some trustees bought into DGFs in the belief that DGF managers have a range of skills, thus offering a simpler solution than building their own portfolio of alternative investments.
So the next stage of our analysis was to extend the regression to include a much wider range of assets that pension trustees may choose to invest in (including different types of bonds, commodities, property, emerging market equity and debt, gold and infrastructure). The results imply that most DGF managers' returns can’t be explained by static weights to this much wider range of assets either. So it looks like they do exhibit good skill (or luck) levels.
So do these managers have skills, or have they been lucky?
To be honest, it’s impossible to say with certainty. Maths simply can’t differentiate between excellent results generated through skill, or excellent results generated through luck. But, over the long run, luck tends to even itself out, so we think it’s highly unlikely that luck alone can make such a difference over the 10+ years that many DGFs have now been running.
So to summarise:
- Are DGFs just an expensive way to access equity and bond returns? No.
- Do they genuinely give investors something different? Yes.
- Are the managers skilful? Some of them almost certainly are.