In 2015, Tony discussed the growing popularity of ‘Diversified Growth Funds’ (DGFs). DGFs typically seek to generate returns comparable to the stock market but with lower volatility. They have been successful at raising assets in a world where many institutional investors have been ‘de-risking’ and the return of capital has been emphasised relative to the return on capital.
Interestingly, in recent meetings with clients, it has been suggested that DGF returns in 2016 were more diverse than in any period since they came to prominence in the financial crisis. How true is this, and what were the causes?
Diversified Growth is not an asset class like equity or fixed income – it is more a strategy to deliver growth while diversifying risk and lowering volatility – and a degree of subjectivity is required in looking at the universe as there is huge disparity across strategies from a traditional equity : bond balanced fund to macro hedge funds and everything in the middle.. The simple increase in the number of DGFs available should also mean a heightened range of returns using most simple measures.
To get around this, the chart below shows the data for the largest funds that we would consider to be DGFs. There were only 10 funds in 2007 with a full calendar year track record and 14 in 2008, but since then we have included the largest 15 funds by end of year AUM (so not a static cohort). Figure one shows returns by calendar year:
Dispersion certainly looks wider in 2016 than it has been since 2008, and this can also be seen in the standard deviation of returns each year.
The picture is similar, albeit less pronounced, if we keep the funds within the universe constant. Figure 3 below shows the returns of the 21 funds which have been in existence since at least 2009. The difference in standard deviation for this universe is less telling, though it is worth noting that in both 2011 and 2013, a couple of outliers seem to be important drivers of this. In 2016 the numbers are more evenly spread.
So it does seem that DGFs delivered a wider range of returns than has been the case for the last five years or so. The reasons for this may seem obvious; many have pointed to the role of Sterling’s large moves and the nature of the ‘shocks’ that took place in the year (which we have previously discussed). How valid are these, and might there be other factors at play?
The role of Sterling
Sterling’s post-Brexit moves have meant that UK investors have had to deal with the impact of currency hedging decisions upon their portfolios in a far more pronounced way than is usually the case.
The conventional wisdom today is that many of the funds that did well in 2016 were those that did not hedge overseas assets (whether because this is their default approach or through an active investment decision). The figure below shows how not hedging (left hand chart) resulted in higher returns, and higher correlation, between global equity and global bond exposures.
It is also notable that there were sharp Sterling moves in 2008, when DGF returns were also diversified.
However there are some problems with this simplistic assessment. If the dispersion was simply a function of those who hedge versus those who don’t, then you may expect the dispersion in 2016 in figures 1 and 3 above to be more bifurcated. Instead they are more evenly spread.
Many DGFs actively manage currency exposures, and though violent currency moves may amplify small differences in overseas versus domestic exposures, it will not entirely explain the differences in return.
What else changed in 2016?
We have noted a couple of times over the last six months that we have just witnessed a short term period which looked very different from the environment that has characterised the last couple of decades. Attitudes shifted in the middle of the year from a sense that the only risk to worry about was weaker growth and stagnation to one in which ‘reflation’ was a possibility, if only a remote one. Added to this has been the bottoming and recovery of many commodity prices and a related pick up in macroeconomic data.
The result was a shift in the market’s treatment of risk. In a world of perceived ‘secular stagnation’ mainstream government bonds could continue to perform their safe haven role, whereas today it is far easier to foresee scenarios that are bond-negative or which harm bonds and equities together. The result has been continued instability in correlation patterns.
The pattern within asset classes has also changed. Last year saw a relatively strong period for value strategies, both within and across indices (figure 7 shows the returns to buying a selection of cheap markets and selling expensive ones and rebalancing each year).
Added to this, as our colleagues at the Equities Forum have recently discussed, has been a decline in correlations between stocks.
Together, these forces suggested that being active played a greater role in returns last year. This was true in terms of both asset allocation and security selection, while the fact that it was in some respects a “year of two halves” meant that dynamism was also critical. These factors account for a wider range of outcomes.
At the same time, those forces which have been tailwinds to more traditional risk management strategies (such as using government bonds and related assets as safe havens, relying on optimiser models for portfolio diversification, or using relative value trades on the basis that previous correlation patterns would hold) were less in evidence. Investors we talk to seem to be far more of the view that low volatility may again be associated with lower return.
Throughout much of last year a key question asked by clients interested in risk reduction was “how was your January?” Checking performance of funds across periods of short term volatility was seen as a litmus test that DGFs could deliver what they promised. This is valid, but it fails to consider how representative January 2016 was of the prevailing regime. Investors would be able to learn far more about DGFs from how they behaved over the year as a whole. It’s often in these periods of short term volatility that opportunities arise and the conviction to make difficult decisions pays off.