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Advisory note Past investment performance is no indicator of future performance. The sterling value of overseas assets in a fund may rise and fall as a result of exchange rate fluctuations. The value of investments and the income from them may fall as well as rise and will be affected by changes in financial conditions. The views expressed in this document are general and not specific to your circumstances.

Authorised and regulated by the Financial Conduct Authority. Registered in England no. 1034719. Registered office: 160 Queen Victoria Street, London EC4V 4AN.

Implementation Considerations Interaction with Existing Investments Many investors use DGFs as a replacement for existing equity investments, with the aim of targeting a similar long-term return to that expected from equities, but with materially lower volatility

Another option is to use DGFs as part of an ‘alternatives allocation’

within the overall portfolio. Potential investors need to consider how any DGF allocation interacts with the remaining elements of the portfolio.

Different DGF Styles Available The DGF universe is heterogeneous, making any comparison between DGF managers extremely difficult. A quantitative comparison of the risk/ return achieved should be tempered by a qualitative analysis of how the funds are managed.

About UsBuck Consultants at Xerox is a leading advisor to mid-sized pension schemes across Europe and North America. We have been providing impartial, trusted advice free from conflicts of interest since 1975 and have a wealth of experience. Our innovative approach to asset allocation is supported by extensive manager research undertaken on a global platform.

Entry Costs The pricing mechanisms and the potential entry/exit costs of DGFs vary considerably and should be taken into consideration when choosing a DGF manager.

Although the impact on a pension scheme’s overall investment portfolio needs to be considered, DGFs represent an appealing way of achieving instant diversification and implementing active asset allocation decisions in one, low governance packaged solution.

Contact UsFor further information and advice please contact your investment consultant or a member of Buck Consultants at Xerox investment team:

160 Queen Victoria Street London EC4V 4AN Tel: +44 (0)20 7429 1000 hrconsultinguk@xerox.com www.xerox.co.uk/HRConsulting

Volume 1

Investment Spotlight is designed to help trustees of mid-sized pension schemes understand key investment areas that impact their scheme. This issue focuses on diversified growth funds (‘DGFs’), i.e., multi-asset funds that target long term returns similar to equities but with lower volatility.

What are diversified growth funds? Diversified growth funds are a relatively new type of pooled fund that invests in a wide variety of asset classes in order to deliver real capital appreciation over the medium to long-term. They aim to achieve ‘equity-like returns over the long term with lower risk’ and offer a more modern approach to the management of a multi-asset class portfolio.

Advantages Diversification of Asset Classes DGFs offer exposure to a broad range of asset classes, which may include UK

Investment Spotlight Diversified Growth Funds

and overseas equities, property, bonds, and also more esoteric asset classes, such as hedge funds, private equity, commodities etc., through a single pooled investment structure. This type of fund structure means that pension schemes are less reliant on one source of return (i.e., equities) when seeking long-term growth in their portfolio.

They are aimed at smaller to mid-sized pension schemes (both defined benefit and defined contribution) and provide an alternative to building a diversified portfolio.

An asset allocation example from a leading DGF is shown in Figure 1 overleaf.

2 Investment Spotlight – Diversified Growth Funds

DGFs principally invest in assets seeking long-term growth, although many allocate to bonds and cash to add a greater level of diversification and to help preserve capital from time to time. While there is no exact definition of a growth asset, these are typically expected to:

• offer a real return, i.e., returns are expected to exceed inflation over the long term

• outperform ‘risk-free’ assets, such as developed market government bonds and cash, over longer time horizons

Reduce Volatility Most DGFs are specifically designed to deliver lower volatility than equities. Consequently, a critical element is the construction of an efficient portfolio (i.e., a portfolio that provides the highest expected return for a given level of risk or the lowest risk for a given expected return, or a combination thereof).

Figure 2 shows the annualised volatility (as measured by standard deviation of returns) on the bottom of six DGFs compared to that of world equity markets over the period 31 January 2007 to 31 December 2012. All of these DGFs demonstrated significantly lower volatility than world equities - with DGF “F” reducing volatility to almost one-third of world equities.

Tactical Asset Allocation Tactical (or dynamic) asset allocation is another key area where DGF managers aim to add value. For example, in a booming economy where companies are making good profits and consumer spending is high, the outlook for equity investments may be good. This, however, may also lead to higher expected future inflation and rising interest rates, which are typically bad for fixed income investments. In this scenario, the manager may tilt the portfolio towards equities.

Furthermore, correlations between asset classes vary considerably over time. A skilled asset allocator may be able to adjust the portfolio to benefit from these changes.

Figure 3 demonstrates how a manager may change the portfolio’s asset allocation over time. It shows the

Figure 1: Asset allocation in a leading diversified growth fund

Source: Buck Consultants

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Figure 3: Tactical asset allocation

Source: Buck Consultants

Figure 2: Annualised volatility vs world equity markets 31 January 2007 – 31 December 2012

Source: Buck Consultants

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Investment Spotlight – Diversified Growth Funds 3

maximum and minimum allowable allocations (for example, the maximum equity allocation is 70% and the minimum is 20%) as well as the actual highest and lowest allocations employed since the inception of the fund (for example, the highest equity allocation employed to date is 60% and the lowest is 30%).

Increasing the Opportunity Set A DGF manager can seek returns from a wide range of possible sources by constructing an optimal portfolio (the strategic asset allocation decision) and tilting the portfolio over time towards higher performing markets (the tactical asset allocation) to generate excess returns. Increasing the opportunity set allows a skilled manager the prospect of delivering the best performance across different time horizons and market conditions.

The Active or Passive Decision Different markets have differing levels of efficiency. In highly efficient markets (such as the UK and US equity markets) it can be difficult to consistently outperform the market over extended time horizons. Within a DGF, the manager is able to allocate capital to an efficient market via a ‘passive’ investment vehicle that targets only the market return, and then allocate the ‘risk budget’ to active management strategies which offer the prospect of delivering skill-based returns in excess of market returns.

Returns Achieved Highlighted in Figure 4 are the returns achieved from six leading DGFs compared to that of world equity markets (light violet line) over the period from 31 January 2007 to 31 December 2012. Four of the six DGFs have performed better than world equities, but two have underperformed (i.e., Managers C and E).

Disadvantages Single Manger Risk The main disadvantage associated with multi-asset class mandates such as DGFs is that all of the assets are potentially invested with one manager. Most managers have strengths in one or two asset classes rather than across all asset classes. (The counter argument is that managers actively invest their fund only where they believe their internal investment managers have a proven and credible track record of outperformance; if not, a passive approach is employed.)

Consequently, many DGF managers place a proportion of the assets with external investment managers. Whilst this may be an appropriate use of capital, one would expect these managers to have a sizeable and credible pool of resources to undertake detailed due diligence and monitoring of third-party managers and their funds.

Tactical Asset Allocation The advantages of adjusting the funds’ asset allocation to benefit from differing outlooks for asset classes appears self-evident, and some managers have the proven ability to tactically allocate capital effectively. However, empirical evidence suggests that timing asset allocation decisions is extremely difficult at best.

Modest Performance and Volatility Track Records Analysis of some of the main providers of DGF products has shown relatively modest performance and volatility track records, with several funds behind their stated performance targets (and world equity markets) since inception.

Fees DGFs typically charge higher fees than a traditional equity mandate, commonly in the range of 0.6% to 1.0% p.a. compared to 0.5% to 0.7% p.a. for actively managed equity funds. Additional expenses can accrue to cover fees for the employment of external investment managers. These fees often arise as a result of the cost of the underlying asset classes in which the fund invests.

Alternative asset classes, especially hedge funds, private equity and currency funds frequently charge higher fees than traditional asset classes.

Figure 4: Returns achieved by DGFs vs world equity markets 31 January 2007 – 31 December 2012

Source: Buck Consultants

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