DIVERSIFIED GROWTH FUNDS: DO THEY MEET EXPECTATIONS?

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1 March 2015 DIVERSIFIED GROWTH FUNDS: DO THEY MEET EXPECTATIONS? In this paper, we ask two questions: Do DGFs meet their objectives? Is their performance good enough? What is a Diversified Growth Fund? DGFs have become an established feature of the investment scene, used by retail and professional investors alike. The key elements of a DGF in our opinion are the absence of an asset benchmark, a wide opportunity set, and a hands-on manager with the ability to make dynamic changes if required. Whilst most DGFs invest a proportion of their portfolios in other managers funds, particularly in specialist areas, we exclude pure multi manager funds from our working definition of a Diversified Growth Fund. How have DGFs performed in this decade? DGFs may be popular, but is their performance giving the level of returns that their investors typically seek? The wide range of targets for both risk and return, and the different comparators used sometimes cash and sometimes a measure of inflation makes assessing performance decidedly difficult. Should each DGF be measured against its own objectives only, or should we ignore these fund-specific targets and compare DGFs with each other? In practice, most analysts, including ourselves, generally take a pragmatic approach, and group DGFs with similar characteristics or objectives together to compare performance, as well as looking at an overall peer group or universe. For the purposes of measuring performance against expectations, we consider here a core list of 16 funds. These funds meet the criteria of an absolute return-type target, a fee level suitable for institutional investment, investable size and a track record of at least four calendar years to end 2014 (traditionally a proxy for the economic cycle). In total, these funds had an aggregated value estimated to be over 60bn at end

2 Comparing DGFs against each other is relatively simple to do. In Fig 1 below, we show the performance and volatility of our core list over the past four years. It can be seen that the trade-off between risk and return is broadly as expected and also that all the funds have underperformed equities, albeit with lower volatility. DGFs have underperformed bonds (which performed exceptionally well over this period) but have had higher returns than other alternative growth assets, such as hedge fund strategies, commodities and return seeking bonds (high yield and emerging market). Fig 1 Diversified Growth Fund Returns and Volatility: 4 years to December 2014 *Other growth assets comprise equal weightings in HFR Fund of Hedge Funds $, Barclays US High Yield $, JPM Emerging Market Bonds $, S&P GS Commodity $ rebased monthly and hedged in Sterling Source: Thomson Reuters Datastream, PiRho 2

3 Measuring DGF performance versus funds individual objectives One way of measuring success can be assessed is whether DGFs have met their own targets. This is by no means straightforward, because Some funds have multiple targets Some funds have no target Time periods may be embedded in targets, or not Targets may be net of manager fees, gross of manager fees, or not clearly specified For targets relative to cash, should we adjust for current ultra-low interest rates? Not all targets are created equal: some may be more aspirational than others: should managers be rewarded for setting an easy target, versus a manager with a tougher target which is not met? With the exception of three funds which do not state an explicit return objective, all the DGFs seek a margin over a cash or inflation measure. Fig 2 overleaf shows relevant cash and inflation variables, along with equities, since (though not always explicitly) many DGFs seek an equity-like return. We have compared, first, the implied expected return of each variable at the end of 2010 and, second, the actual compound return over the subsequent four years. For example, markets in 2010 were pricing in expected rises in cash rates over the coming 4 5 years. Despite base rates being 0.5% p.a. at end 2010, an investor at that date could reasonably expect that holding cash would give an average return in excess of the prevailing base rate. We have estimated that markets were pricing in that cash would return 1.8% p.a. for longer term investors and that retail price inflation would grow at approximately 3.4% p.a.. We have further estimated the longer term return of equities using Gordon s Growth model approach and inputting the market rates that existed as at 31 December As can be seen, with the exception of equities, all of the target variables became easier to meet over the period. Fig 2 DGFs typically target returns over either cash or inflation variables Source: PiRho, Thomson Reuters Datastream 3

4 Prior to 2010, it was reasonable to expect that cash rates would be slightly above inflation in the long run (see Fig 3). Hence for a DGF launched before this decade, a cash plus 3% target would be expected to be more challenging than an inflation +3% target. However, this has not been the case since the financial crisis, as over-night cash rates have been kept at ultra-low levels for an extended period (see chart below). Fig 3 Inflation and cash rates Source: Thomson Reuters Datastream In Fig 4 we show 16 DGFs in the PiRho universe with their primary individual stated targets, ranked in order of expected return based on market data at the end of Based on this data, Fig 4 shows that there is a very significant gap, of over 5% p.a., between the highest and lowest implied target return. 4

5 Fig 4 Implied DGF Return Targets, ranked by implied target return in December 2010 Fund name Primary return target (p.a.) Net / Gross of fees * Implied return net of fees in Dec 2010 (%p.a.) Secondary return target (if any) Risk target (if any) Aberdeen Multi-Asset RPI + 5% N 8.4% Positive yearly return, beat inflation by a significant margin in long term Low absolute volatility M&G Prudential Absolute Ret. Strategy CPI + 5% N 7.7% None Not specified Schroder Life Diversified Growth RPI + 5% G 7.6% Equity-like returns 2/3 of equity risk Pyrford Global Total Return Sterling RPI + 5% G 7.4% None Not specified Blackrock Market Advantage Strategy 3m LIBOR + 5% G 6.4% Equity-like returns 2/3 of equity risk Standard Life Global Absolute Ret. Strategy 6m LIBOR + 5% G 6.1% None Not specified Baring Dynamic Asset Allocation 3m LIBOR + 4% N 5.8% None Not specified Baillie Gifford Diversified Growth Base Rate + 3.5% N 5.3% None Volatility below 10% p.a. F&C Diversified Growth 1m LIBOR + 4% G 5.1% Equity-like returns in medium term 2/3 of equity risk (below 10% p.a.) Newton Real Return 1m LIBOR + 4% G 5.1% Positive return on a rolling 3-year basis Not specified Blackrock Dynamic Diversified Growth 3m LIBOR + 3% N 4.8% None Bond-like volatility Insight Broad Opportunities 3m LIBID + 3% N 4.7% Equity-like returns over the medium term Volatility markedly lower than equities Newton Phoenix Multi Asset 1m LIBOR + 2% G 3.2% None Not specified Putnam Investments Total Return not specified n/a n/a None Not specified Ruffer Absolute Return not specified n/a n/a Positive returns Low volatility Troy Asset Management Trojan not specified n/a n/a Growth in capital and income in real terms in long term Not specified * Target net of fees (N), gross of fees (G) Source: PiRho; Data: Managers, Thomson Reuters Datastream 5

6 Results: DGF performance versus funds individual objectives In Fig 5 below, we analyse whether DGFs implied return targets have been achieved over the subsequent four years. Fig 5 DGF Performance versus Fund Targets, 4 Years to December 2014 Fund name Actual 4-year net returns (%p.a.) 4-year implied target return in Dec 2010 (net of fees, %p.a.) ex-ante Ex-ante target achieved? 4-year retrospective target return as at Dec 2014 (net of fees, %p.a.) ex-post Ex-post target achieved? Aberdeen Multi-Asset Fund 6.2% 8.4% No 8.2% No M&G Prudential Absolute Ret. Strategy 6.5% 7.7% No 7.5% No Schroder Life Diversified Growth Fund 4.9% 7.6% No 7.4% No Pyrford Global Total Return Sterling 3.4% 7.4% No 7.2% No Blackrock Market Advantage Strategy 6.0% 6.4% No 5.3% Yes Standard Life Global Abs. Ret. Strategy 5.7% 6.1% No 5.2% Yes Baring Dynamic Asset Allocation 4.8% 5.8% No 4.7% Yes Baillie Gifford Diversified Growth Fund 4.6% 5.3% No 4.0% Yes Newton Real Return 3.1% 5.1% No 3.8% No F&C Diversified Growth Fund 2.3% 5.1% No 3.8% No Blackrock Dynamic Diversified Growth 4.6% 4.8% No 3.7% Yes Insight Broad Opportunities Fund 4.9% 4.7% Yes 3.6% Yes Newton Phoenix Multi Asset 4.1% 3.2% Yes 1.9% Yes Putnam Investments Total Return 5.8% - n/a - n/a Ruffer Absolute Return 4.5% - n/a - n/a Troy Asset Management Trojan Fund 4.0% - n/a - n/a Source: PiRho; Data: Managers, Thomson Reuters Datastream As can be seen, while the actual, retrospective targets (which are in all cases lower than the implied targets in end 2010) have been slightly more achievable, even then only around half the funds have achieved their stated targets. 6

7 Conclusions DGFs have a wide range of expected returns, suggesting that we should look at performance versus individual fund target, as well as versus a peer group. Target returns have been lower in absolute terms over the last four years than in the past, primarily because interest rates have remained ultra-low. Equities and bonds have performed well in the past four years although other growth assets (such as commodities and hedge funds) have lagged. Just over half of the DGFs have out-performed their own targets (based on the lower actual cash and inflation returns) over the last four years. Most of the DGFs have under-performed their own targets (based on implied expected returns as at end December 2010); none have matched UK equities, Gilts or UK Corporate bonds over the same period. Overall, investors in DGFs expecting equity like returns with lower volatility over an economic cycle would for the most part be disappointed with the performance of DGFs over the past four years. The determination of governments post the financial crisis to support economic growth has contributed to strong equity markets as well as strong bond markets. In these circumstances, diversification at the heart of the Diversified Growth Fund has not paid off as compared with a simple equity and bond portfolio. We would give a mixed score card to DGFs over this period. Funds with high targets are more likely to have missed their performance objectives than funds with low targets; in our opinion, this by itself should not be held against these funds when making fund selections. We believe to really understand the likely performance characteristics of a fund it is necessary to look under the bonnet and examine the manager s approach to risk management rather than simply relying on the fund s stated objective. Nicola Ralston and Krzysztof Lasocki 7

8 DISCLAIMER This document is for information purposes only. The information contained in this document has been compiled by PiRho Investment Consulting Ltd from sources that it believes to be reliable but no representation or warranty is made or guarantee given by PiRho or any other person as to its accuracy or completeness. Information contained herein is not a solicitation, commitment or offer to buy or sell, nor is it an official confirmation of terms. Past performance is not necessarily a guide to future performance. All opinions and estimates expressed in this document are (unless otherwise indicated) entirely those of PiRho as of the date of this document only and are subject to change without notice. This information is not intended for use by any person(s) within the jurisdiction of the United States of America. This document may use several indices for comparative purposes. However, any investment fund(s) referred to will not necessarily attempt to replicate the performance of these indices. Comparison with any indices should not be understood to mean there will necessarily be a correlation between a fund s return and these indices. Securities in a fund s portfolio will not necessarily include securities represented in these indices. Given the specific characteristics of each fund any such comparison should be made with the greatest caution. Each recipient of this document shall be solely responsible for independently confirming the information contained herein and for making its own independent investigation of the investment fund referred to in this document. Investment in funds may involve a high degree of risk. As market risks are inherent in all securities investments to varying degrees, there can be no assurance that the investment objective of any fund will be achieved. Practices of short selling, leverage, limited diversification and the use of derivatives instruments, executing trades on foreign exchanges can in some circumstances substantially increase any adverse impact on a fund s investment portfolio, resulting in high volatility levels as well as the risk that the entire amount may be lost. This document is not an offer to sell or the solicitation of an offer to buy or subscribe to any investment fund. Any investment fund referred to in this document may not be eligible for sale in some jurisdictions. Neither PiRho nor any other person accepts any liability whatsoever for any loss howsoever arising from any use of this document or its content or otherwise arising in connection therewith. Past performance is not a guide or otherwise indicative of future results, and investors should be particularly aware of the risk of interpreting short-term performance records in any manner. The investment funds referred to in this document may not have been registered or qualified with, nor approved or disapproved by the U.S. Securities and Exchange Commission, the Financial Conduct Authority or any other regulatory authority, nor has any regulatory authority passed opinion upon the accuracy of any information contained herein. Any recipient of this document who requires further information regarding the investment funds referred to in this document or wishes to distribute this document should contact PiRho at its business address, otherwise any distribution or reproduction by recipients is strictly prohibited. PiRho Investment Consulting Ltd is authorised and regulated by the Financial Conduct Authority. The Financial Services Register number for PiRho Investment Consulting Ltd is PiRho Investment Consulting Ltd is a limited liability company registered in England, No VAT Registration Number: Address: 13 Austin Friars London EC2N 2HE. Contact: Phil Irvine phil.irvine@pirho-ic.com Nicola Ralston: nicola.ralston@pirho-ic.com