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

Diversified growth, multi-asset, multi-strategy — these are some of the terms used to describe investment options for pension plans seeking the sweet spot of equity-like returns with lower volatility by investing across a broader range of asset classes.

It’s not a new approach, as diversified growth funds have been spreading from their roots in Britain for more than a decade. But as pension funds seek ways to overcome the challenges of the current investment environment, the area of multi-asset investing continues to evolve. In Canada, while there’s interest in the approach, it has yet to truly take off, says Gilles Lavoie, a senior investment consultant at Willis Towers Watson in Montreal.

“The pickup rate hasn’t been that great,” says Lavoie.

One of the trends in the multi-asset area is the idea of so-called alternative risk premia. The idea is to focus on factors other than traditional measures, such as bond duration, according to Jérôme Teiletche, managing director and head of cross-asset solutions at Unigestion. On the equity side, the approach can include premiums such as value, momentum, quality and size, and it typically involves long/short strategies in order to reduce exposure to general market trends, says Teiletche. “By being long and short, you extract even better the risk premium.”

A strategy of currency carry is one of the most emblematic examples of an alternative risk premium, he notes. By ranking a set of currencies according to short-term interest rates, an investor can go long on those with higher yields and short on those at the bottom of the list. By doing that, an investor can extract the interest rate differential, says Teiletche, citing the example of going long on the Australian dollar and shorting the Japanese yen. “The strategy is absolutely not at all new,” he says. But what is new is the move to apply the approach to other asset classes.

Tracking the performance

While some aspects of the multi-asset approach are similar to hedge funds, one advantage is the lower fees. “The issue is disappointment more than anything else,” says Teiletche, referring to disenchantment by some investors with the fees charged by hedge funds relative to the returns achieved.

Brian Cyr, managing director at investment consulting firm bfinance in Montreal, says fees for funds involving alternative risk premia often fall in the area of 75 basis points, an amount he suggests is reasonable to pay for a more sophisticated investment. But while diversified growth funds have generally performed well, a key question is whether they deliver returns that justify paying more. In a report last year, Willis Towers Watson noted that while many funds have achieved their targets, they’ve done so amid a positive market environment in recent years. So if the environment were to turn, would diversified growth funds do any better than the rest of the market?

That’s where funds involving an alternative risk premium can play a role, says Cyr, since the idea is to reduce correlation.

For his part, Teiletche admits that it’s unclear how multiasset investments would play out in that scenario since the approach is a relatively recent one that really took off following the 2008/09 financial crisis. “For sure, a traditional portfolio will suffer,” he says, noting his belief that a more active approach will perform better. “It’s more the conviction that doing nothing in such an environment will not be favourable.”

As for some of the strategies that underpin the idea of alternative risk premia, Cyr notes there are risks. When it comes to the long-short approach to equities, for example, he points out that the results may be disappointing when the overall market is rising. “In that context, long-short has not done so well,” he says. Cyr also questions the currency strategies that often arise in discussions about alternative risk premia. “It’s still very marginal . . . in terms of allocations to active currency strategies,” he says.

Time for smart beta?

In its report on diversified growth funds, one of the solutions recommended by Willis Towers Watson was the consideration of smart beta approaches. Cyr acknowledges that smart beta can allow investors to capture specific risk factors, such as momentum, through a strategy that brings a more active flavour to a passive approach. Still, he calls smart beta a “nice fancy term” that still involves significant correlation to the market.

So whether you call it diversified growth, multi-asset or multi-strategy, investors may still see some upside in that approach. The approach was attractive enough to bring the OPSEU Pension Trust on board with Aviva Investors’ launch of a multi-strategy target return pooled fund last year. For Cyr, one of the key attractions of the multi-asset approach is the ability to be dynamic and tactical in adjusting portfolios more quickly.

“The greatest lesson learned for pension plans following the [global financial crisis] is that the governance imposed by just managing a pension plan doesn’t allow them to make decisions rapidly,” he says.

Lavoie, too, says the approach has its merits. “Conceptually, we’re fully supportive of it,” he says, adding his concern about the potential overreliance on one manager. “In practice, you find there are certain drawbacks.”

Glenn Kauth is the editor of Benefits Canada.

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