15 December 2020
This is the second instalment of my three-part blog looking at some of the components of the DC lifestyle strategy and what the Covid-19 pandemic taught us about how they perform.
In my first blog, I looked at the accumulation phase and the regional equity allocation of the lifestyle. This time, I will focus on a DC staple, the Diversified Growth Fund; these funds often have materially different asset allocations and as such, performed very differently through the Covid-19 pandemic.
Many of my clients use a Diversified Growth Fund (‘DGF’) in both the consolidation and de-risking stages of their investment lifestyles. Recently, my clients have been revisiting this allocation - why now? Well, two reasons really;
1. Market conditions
Most DGFs tend to be benchmarked against a long-term performance comparator. Often a ‘cash plus’ or ‘inflation plus’ target. For example, stating that over the ‘market cycle’ the fund will achieve for example, cash + 3-5% - such a benchmark can prove tricky to monitor the performance of these funds against in the short term. However, when reflecting on longer time horizons, the characteristics of the fund and especially how it performed in specific market environments can be lost or forgotten in the ‘aggregate’.
The calendar year 2020 has provided Trustees with the unique ability to monitor DGF performance in essentially a compressed ‘proxy’ market cycle:
- In March we saw some of the worst days of equity returns since the great depression and a month that returned -c20% in some equity markets.
- Similarly, since March, we have also seen one of the best equity rallies in recent memory – with overseas equities returning nearly 40% since the start of April (to 30 November).
As such, rather than focus on short term performance, it has been a good time to analyse metrics not as frequently discussed at quarterly Trustee meetings; upside capture (post March) and downside avoidance (in the month of March) along with correlations with different asset classes to see what characteristics DGF’s portray in the different market conditions we saw in the 6 months from February.
The chart below shows the LCP universe of DGFs we research and their respective performance over the calendar year to the end of November. What is immediately obvious to me is the dispersion of performance f; as much as a 14% difference in return and similarly almost 15% in volatility differences over the same period. This really highlights that whilst DGFs may all be branded the under the same name, the underlying funds and their characteristics differ significantly. So why are there such differences?
2. Diversification properties?
When you think of DGFs, you naturally think of a diversified portfolio, it is after all in their names! But are they living up to this? Diversification can come in many different forms and therefore the two key questions I have been focusing on with my clients are:
- Diversification from what?
- How regularly is the asset allocation reviewed and changed?
In my experience the underlying asset allocation within DGFs and the dynamism is crucial to both the performance of the funds and where they should be used in the lifestyle. For example, consider two DGFs, each from a different one of my clients.
|DGF 1||DGF 2|
|Total Equity allocation||43%||22%|
|Emerging Market Equities||33% of equity holding||11% of equity holding|
These DGFs will perform materially different in different market environments. DGF1 will have a reasonably high correlation to equities (and so perform similarly). Therefore, it may be appropriate for clients with a primary focus on participating in any strong market conditions to access additional incremental return, with diversification as a secondary objective. DGF2 however may be more appropriate as a purer diversifier from equities. Both are suitable for client circumstances, but these circumstances can differ considerably. For example, in July, one of my clients reviewed their DGF and concluded they were comfortable that their DGF lagged behind competitors in the equity rebound, knowing that their DGF is paired next to an equity fund and the other allocations in the DGF (for example to precious metals) could be well suited to support performance should equity markets crash again.
3. Active v Passive
Finally, in recent years there has been a gradual transition of DC money from actively managed more dynamic DGFs (in light blue on the chart below) to passively managed DGFs (in dark blue). For the four calendar years 2016-2019, active DGFs lagged passive counterparts significantly. Many active DGFs adopted a more cautious asset allocation than passive DGFs (or DGFs allocating to traditional asset classes), many of whom performed well as a result of a higher equity allocation, as outlined below.
However active managers have always stated that with market volatility is opportunity and this claim seems to have been justified in 2020. On average, active funds have provided similar returns to passive peers, but with less volatility. For many Schemes, this is a desirable trait, especially in the consolidation and de-risking phases of a lifestyle.
Therefore, I see the calendar year 2020 as providing market conditions useful to monitor your DGFs. You should ask yourselves:
- What is the asset allocation of your DGF and how much does it vary?
- When is the fund expected to perform well? Did they perform as expected this year?
- What asset classes are the best complement to your DGF if you use them in your lifestyle strategy?
- Do we want dynamism from the DGF or static predictable asset allocation?
In my view, answering these questions whilst reflecting on 2020 will be invaluable to answering how member performance will respond in market conditions looking forward.