Digging deeper in DGFs

Written By: Thomas Nehring Head of Institutional & Wholesale Distribution UK & US Nordea Investment Management

Thomas Nehring of Nordea Investment Management identifies the reasons for the growing popularity of Diversified Growth Funds and outlines Nordea’s “stable investment” policy towards these multi-asset solutions

Multi-asset solutions or “Diversified Growth Funds”, more commonly known as DGFs, have experienced a surge in popularity in the UK over the past few years – fast becoming the most sought after new investment mandates.

These vehicles have become important components of pension schemes, as DGFs offer the benefits of liquidity, simplicity and relatively low fees – particularly compared to multi-asset counterparts.

DGFs have become especially popular with UK defined benefit plans, and it is easy to see why. Generating sufficient returns to meet liabilities has become a huge challenge for pension funds. Bond yields are low, and the rollercoaster for equity markets since the financial crisis has dented asset growth. In addition, the list of asset classes available for selection by allocators has lengthened, while resources dedicated to fully understanding and analysing these asset classes have not necessarily increased. As such, there is obvious appeal in employing a multi-asset strategy and allowing the portfolio manager to focus on delivering strong diversification.

These vehicles are also growing in appeal among other UK institutional investors, particularly as DGFs can demonstrate diversification benefits within a broader asset mix. While the UK was largely responsible for the recent increase in searches for multi-asset strategies, the appetite for multi-asset funds has been growing strongly on a global scale – be it in the US, Continental Europe or Asia.

To keep pace with this growth in demand, multi-asset product providers are keen to innovate and differentiate themselves. The range of multi-asset strategies available to investors is therefore increasing. Each DGF has a different blend of assets and no common benchmark for multi-asset strategies exists. However, the goals of these multi-asset solutions are typically the same, as these strategies attempt to meet the generic investor need of good downside protection, attractive returns and diversification.

The investment approaches employed to achieve the aforementioned targets vary widely. Many approaches are employed within the multi-asset sphere: strategic DGFs, dynamic DGFs, absolute return funds, target return funds and target absolute funds. Each investment philosophy is different and can include a broad range of financial assets. This is where investors need to be highly vigilant.

One common challenge for DGFs today is to ensure robust diversification for their investors, thus providing good downside protection of capital during volatile market periods. However, in recent periods of market turbulence, many asset classes have been shown to become highly correlated. The supposed diversification benefits evaporated when most needed.

That is exactly what happened during the taper tantrum of 2013, when correlation between Global Equities (represented as MSCI ACWI) vs Global Bonds (represented by Barclays Global Aggregate Total Return Index) reached the elevated levels of 0.37, severely impacting what were supposed to be well diversified portfolios.

Not only have correlations between Global Equities and Global Bonds increased in recent years, other asset classes that were regarded as diversifying are moving in closer lockstep. Investors need to explore new ways to diversify their portfolios.

This poses a big challenge for multi-asset strategies, as investing in different asset classes alone does not ensure a portfolio is well-diversified from a downside protection perspective.

This challenge is not new. At Nordea, we took a decision almost a decade ago to shift our investment focus away from asset class investing – such as top down or directional/beta investments – to focus on risk premia. By identifying the underlying risk and return drivers of an asset class and their true diversification characteristics, rather than asset classes per se, it allows for a more robust diversification, thus better downside protection and the ability to deliver a positive stable total return over time and in different periods of economic cycles.

Another key test for multi-asset solutions over the last decade has been in the extraction of yield. The low yielding environment from the financial crisis has forced many DGF strategies to take on more risk in order to generate returns. This has led to a rise in investments into more illiquid assets.

While this approach is acceptable at times of buoyant optimism, it can also prove painful and problematic for investors in risk assets when the tide turns – as seen on more than one occasion in recent times. This has certainly been the case this year, as volatility returned to global investment markets.

Energy price swings, a potential “Grexit”, anxiety due to a potential Fed rate hike and fears over the possibility of a hard landing in China were the reasons sparking market volatility. All these events pushed risk aversion to highs not experienced since 2011, prompting sharp daily movements in major risk assets.

When volatility increases, it often leads many multi-asset solutions to shy away from equity markets and look to less sensitive assets. Often this means higher allocations to bond markets, even though many market participants believe there is limited upside in many areas of fixed income markets. We take a different approach.

We can afford to carry higher weightings to equity markets because we break the asset class into different sub-components and try to determine which return driver offers the most compelling risk/reward characteristics. The fund explicitly exploits the low volatility premium within both the Developed and Emerging Equity Markets through our “stable equity” investment philosophy, which invests in companies that display steady business models, with somewhat predictable earnings profiles.

Because of their high quality nature, we believe a 50% allocation to stable equities is roughly about the same risk as traditionally taking a 30% weighing in stocks. It is a contrarian way of looking at risk, but at a time when many investors are concerned about capital preservation on the bond side, we believe you can enhance capital protection by transitioning your portfolio into high quality stable equities. Stable equities are also more robust to interest rate increases.

Again, no matter what market environment we are facing, at Nordea we always consider risk first and avoid stretching for returns. We do not want to deviate from our focus on ensuring capital preservation over a three-year time horizon. With this risk budget in mind, we then look to generate the highest return possible.

Following this process of capital preservation through consistent and stable returns helps avoid the roller coaster performances some market timing multi-asset funds endure. Having a holistic view on risk allows us to generate robust performance, with a low volatility and drawdown.

As the DGF space continues to grow in demand, so do the varied strategies on offer. It is vital investors look under the bonnet of the solutions in this deepening universe to ensure it can meet the challenges inherent in today’s investment markets.