Back to basics on diversified growth funds

Canada has learned a lot from the U.K. Diversified growth funds, which began crossing the pond in 2008, are the latest import. But the funds still haven’t gained much traction over the last decade, though they do offer pension plans another option in their portfolio.

A diversified growth fund is a fund that targets a return — normally, inflation plus four or five per cent — by holding a number of different asset classes, says Bradley Hough, a partner and senior investment consultant at PBI Actuarial Consultants Ltd. “So equities, real estate, hedge funds and other things and an allocation to bonds, corporate bonds.”

Follow the leader

In Canada, there are three reasons diversified growth funds could follow the lead set by the U.K. and the U.S., according to a paper by Connor, Clark & Lunn Financial Group:

1. Many investment firms are better equipped to offer a diverse range of solutions under a single firm.

2. Investors recognize the merits of alternatives, but are conflicted by the complexity and governance implied by alternatives. The approach can provide allocations to alternatives without the burden of a large roster of managers and associated governance complications.

3. The approach can provide plan sponsors with an alternative to a full outsourced model.

The approach allows for a much smoother return than a conventional balanced fund, he notes.

Read: Can alternative risk premia boost the outcomes of diversified growth funds?

During 2008’s significant market correction, many pension plans were exposed to balanced funds with a 60/40 traditional equities/bonds mix, says Marcus Turner, senior director of investment consulting at Willis Towers Watson. Of course, he adds, they were hit hard when equity markets collapsed.

As a result, plans began turning their attention to diversified growth funds as a way to vary their equity-heavy portfolios. “Seventy-five per cent of the composition of diversified growth funds are global or emerging market equities, global or emerging market bonds and then some high investment grade or high-yield bonds,” says Turner.

The other 25 per cent is typically made up of cash and alternatives, such as hedge funds, private equity, real estate, infrastructure and commodities. “The best way to think of a diversified growth fund is . . . as a diversified balanced fund where the manager is pulling more levers than the traditional fund,” he says. “They add a few more levers or tools in the manager’s toolbox that you don’t typically get in a balanced fund.”

Already diversified

Diversified growth funds aren’t common in Canadian defined benefit plans, says Hough, because these plans are already diversified. “You could argue they’re already a diversified growth fund.”

Also, the funds’ alternatives are mostly liquid, such as listed infrastructure and real estate, while most Canadian plans typically see more value in private assets, he adds. So smaller pension plans, which are less able to invest in alternatives, may find diversified growth funds to be an ideal solution.

On the other hand, the funds are typically used in defined contribution plans, especially in the U.K. and the rest of Europe, where many DC platforms and insurers are offering the option, says Hough. “This could be a useful solution for DC plan members who want higher returns than target-date funds may provide, but prefer a pre-defined asset mix to creating their own.”

Read: What can Canada learn from Britain’s pension reforms?

Also, diversified growth funds have traditionally been a challenge for plan sponsors to benchmark because of their complexity. “It isn’t always an apples-to-apples exercise,” he says, referring to each fund having a different strategic asset allocation.

“But I think Canadian investors are now used to things with different benchmarks, so I think that will be less of a hurdle for Canadian pension plans to get over than it was in the past,” adds Hough.

Turner expects the funds to see traction in individual savings plans, because they offer a more diversified portfolio of investments than a typical balanced fund. “The only caveat is that there’s a lot of other competition that may be a little more dynamic,” he adds. “There may be some growth there, but I don’t see this catching fire.”

Alethea Spiridon is managing editor at Benefits Canada.