DGFs — another over-marketed investment product to avoid

Posted by Robin Powell on March 3, 2016

There’s a fairly reliable rule of thumb in asset management that the more hype and expectation that surrounds a particular product, the more it costs and the lower the net returns it delivers to investors. Diversified growth funds, or DGFs, are a classic example.

Diversified growth funds have been one of UK fund industry’s top-selling products of the last 10 years. By March 2015, they had attracted £150 billion of assets — up from £100 billion just 15 months before. They are expected to hit £200 billion by 2018.

What these funds claim to do is to generate alpha by diversifying across different asset classes — mainly equities, bonds, property, private equity, commodities and currencies. Because managers have the freedom to switch between different assets, the hope is that investors can enjoy long-term, equity-like returns, but with lower volatility.

Diversified growth funds have been particularly aggressively marketed at pensions funds and other institutional investors.

But like so many investment products that seem to offer much, they’ve actually delivered very little. Cambridge Associates surveyed 35 large diversified growth funds and found that the average fund lagged a simple 60:40 balanced fund by nearly 330 basis points — or 3.3% — between 31 October 2007 and 31 March 2015. That equates to £37 for every £100 invested at the outset.

The researchers also identified a huge dispersion in performance. In the 12-month period to the end of March 2015, for example, the difference between the best and worst performing funds was an almost unbelievable 2,600 basis points, or 26%.

So, why have diversified growth funds performed quite so badly? Well, separate research recently conducted by Buck Consultants offers two useful clues.

First, diversified growth funds typically allocate a proportion of their assets under management to other fund managers, often hedge funds or other niche funds specialising in particular areas. The researchers found that those external funds have tended to act as a drag on overall performance.

That can partly be explained by the “double fees” effect — clients, in other words, aren’t just paying the DGF manager but also the other managers that he or she chooses to use. But the study also found widespread evidence of poor fund selection. That’s right, even fund managers find it very hard to spot talent among their fellow managers.

The second contributor to underperformance, the study found, was that managers were not very good at switching between the different asset classes at the right time.

Nicholas Ridgway, Buck’s head of manager research, told Financial News: “Assessing DGF managers’ asset-allocation skills is the controversial bit. They have generally claimed that about 20% of their returns will come from this.

“But what has happened in reality is that managers have been unable to attribute this. How do you attribute active asset allocation when there is no benchmark portfolio? So what this means is they just report asset allocation in with the market return. We are suggesting that this is likely to overstate managers’ skill.”

Yes, you read that correctly. DGFs are able to disguise quite how badly they perform by simply fudging the data and hoping nobody notices.

So, what are the lessons to learn, apart from avoiding diversified growth funds? First, not even fund managers can identify in advance the very funds which will outperform the market in the years ahead, so don’t even try it. Use low-cost index funds instead.

Secondly, neither fund managers nor anyone else can reliably rotate between different asset classes, getting in just as markets start to rise and out just as they’re about to fall. All the evidence shows that you’re better off avoiding market timing and staying diversified.

And another thing. Be especially wary of heavily promoted products that appear too good to be true, that hint at juicy returns with a reduced level of risk. There’s no magic ingredient to them, and they don’t do anything that you couldn’t do far more cheaply and efficiently yourself, or with the help of an adviser.

Investors who opt for these sorts of products think they’re paying for complexity, for skill and expertise; they’re really paying for marketing and very large salaries. We all have more important things to spend our money on.

 

Related posts:

Multi-manager funds — Who needs ’em?

Why the investing industry loves complexity

Robin Powell

Robin is a journalist and campaigner for positive change in global investing. He runs Regis Media, a niche provider of content marketing for financial advice firms with an evidence-based investment philosophy. He also works as a consultant to other disruptive firms in the investing sector.

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