Roiling volatility puts diversified growth funds on minds of many

While the return of volatility to the markets and increasing monetary policy divergence weigh on the minds of single-strategy investors, these factors might be just what diversified growth strategies need.

Consultants and money managers said the strategies — most commonly labeled diversified growth or multiasset strategies — have come under increased scrutiny from investors and consultants for their performance. Some say that the strategies, which aim to deliver a smooth ride by investing across asset classes, producing equity-like returns but avoiding the volatility and potential losses associated with bumpy markets, have failed to produce better returns than a simple, balanced portfolio. Strategies were put to the test at the start of this year thanks to shocks from China and the fear of a potential U.K. exit from the European Union; and last summer, as global markets suffered from short-term crashes.

Sources that run these types of strategies pointed out that they typically suffer around one-third to one-half of the losses equity markets suffer in negative periods, but also will not necessarily hit the highs that equities achieve in the good times. Hani Redha, multiasset portfolio manager at PineBridge Investments in London, said that over a three-year period to June, diversified growth strategies achieved monthly returns of between -3% and 4%, compared with FTSE All-Share monthly performance of between -7% and 7%.

Experts expect the protection against volatility that these strategies provide to lead to increased allocations by institutional investors globally. PineBridge expects 27% growth in diversified growth assets this year, to total £160 billion ($230.3 billion). Sources also attributed growth forecasts to increased allocations from defined contribution plans, and to the performance of some diversified growth strategies.

“Since inception, we have delivered an improvement in risk-adjusted returns relative to equities,” said Johanna Kyrklund, head of multiasset investments at Schroders PLC in London. “That is ultimately what the diversified growth universe is about — delivering a smoother path of returns” than equities. The firm runs £78.1 billion across multiasset investments.

Institutional assets have continued to flow into the strategies — albeit at a slowing pace. eVestment LLC, Marietta, Ga., data show net institutional inflows totaled $70.5 million for the three months ended Dec. 31, compared with $1.2 billion for the three months ended Sept. 30; and $3.3 billion in the three months ended Dec. 31, 2014. Institutional assets in diversified growth strategies totaled $87 billion at Dec. 31, up 4.4% year over year.

And the return of volatility to the global markets will give managers and certain substrategies within the diversified growth universe an opportunity to prove their worth, with dispersion in stocks and ever-diverging monetary policy set to benefit alpha-seeking and more dynamic strategies in particular.

“Heightened volatility will give a high dispersion of returns, certainly with the active managers, and the out- or underperformance will become maybe more magnified,” said Nick Ridgway, head of investment research at Xerox HR Services, based in London. “Going forward, the skill of DGFs vs. balanced funds potentially has more of an opportunity set in a world where volatility is much higher, and you do need to access a broader asset base.”

And long-term investors need to think about volatility, said Ms. Kyrklund. “The view on whether volatility matters also is a function of market conditions — when we are in a bull market, typically investors say they don't care about volatility. Over recent years that has been one of the issues. But I think the volatility argument will become more prevalent.”

The forecasts come as the spotlight is shining on these strategies regarding performance vs. traditional 60/40 portfolios. In a survey released in October of 35 diversified growth portfolios with at least £30 million in assets, Cambridge Associates found that the median fund manager lagged a 60/40 portfolio by almost 330 basis points between Oct. 31, 2007, and March 31, 2015.

“Performance of DGFs has been mixed — you can see a number of them have outperformed their own performance objective of LIBOR plus 4% — but that hasn't been that difficult when LIBOR has been so low,” said Alex Koriath, head of the U.K. pension practice at Cambridge Associates Ltd. in London. “On the other hand, they haven't really outperformed a more simplistic strategy.”

Cambridge Associates' research also found dispersion in returns, with the top 25% of diversified growth portfolios outperforming the bottom 25% by 110 basis points per year over the past five years.

However, it is difficult to judge the performance of some of these strategies, since recent volatile periods might have been the first for many. Aniket Das, senior vice president, manager research, at Redington Ltd. in London, said the consultant tracks more than 50 diversified growth strategies, compared with about 30 three or four years ago. “Most of them weren't around in the global financial crisis — this is their first, I'd say, serious bout of volatility. I've told a lot of DGF managers who have popped up in the last few years that we really needed to see them go through a bout of serious market volatility — I'm not talking the eurozone (debt crisis) in 2011, or the taper tantrum in 2013; but something much more significant and prolonged. This is shaping up very much to be that type of situation, starting August last year,” he said.

While inflows do continue, “we are also starting to see (diversified growth strategies') first outflows,” said Mr. Ridgway. He said that could be due to the scrutiny they have come under as beta has prevailed in the markets in recent years, meaning DGFs generally have lagged equity markets and investors may have become “disillusioned” and moved their assets.

But clients should not be too quick to switch. “We have said to clients that these are not capital preservation products, but ones that will go down with markets in most circumstances, but should be going down by less,” said Robert Howie, principal at Mercer Investments in London. “Maybe there is a misunderstanding from people who have bought these products. They are trying to give you lower volatility than equities — hopefully investors are fully expecting negative returns when (markets are down,) but better returns than equities” in those situations.

A more volatile markets environment has refocused the minds of some money managers. “We're coming from a period of seven years of good gains (in part thanks to) central banks, which have pushed everything up, and probably going toward seven years of poorer returns in terms of beta and directionality,” said Marino Valensise, head of Baring Asset Management's multiasset group, based in London. “So (diversified growth) managers should — and we are trying to — rely less on beta, choose our betas carefully, and be more dynamic in how we rotate the betas. That means in practice that the DGF community will have to migrate away from holding static long-term positions in the S&P 500 to being more dynamic.” Barings' Dynamic Asset Allocation fund has about £1.7 billion of assets, all from institutional clients. Globally, the firm has £6 billion in multiasset strategies.