The pros and cons of four alternative DC investment approaches

Trustees of defined contribution (DC) schemes have never had more choice in the range of available investment options. Here we analyse the strength and weaknesses of four alternative approaches to passive global equities and diversified growth funds, which have featured heavily in DC strategy design to date. 

Factor investing

Also known as smart beta, this approach offers different drivers of return to market cap weighted investing. And with fees as low as 10-15bps it is usually much cheaper than active management.

Its cheapness arises from a data driven approach to selecting equities based on factors such as value, momentum, size or market volatility. These styles are not new to investment markets, so we have to be careful this is not presented as something completely new for schemes.

The trouble with this approach is that while these factors can be back tested to show outperformance of a market cap weighted index, it is very easy to hand pick a timeframe to prove this argument. All factors have at times under-performed market cap indices. Ideally, a fund manager is allowed to dynamically switch between factors to avoid such underperformance, but this increases fees.

Illiquid assets

There is an increased acknowledgement that DC investors at the start of their savings journey are long-term investors, so they should participate in a broad range of assets, including those paying an illiquidity premium.

One of the barriers to this style of investing has been the need for a daily price for assets which are not traded on a public exchange. However, an experienced private markets manager has now introduced a daily priced fund providing exposure to private equity and debt, property and infrastructure.

Its annual management charge of 1.25 percent plus an additional performance-related fee will no doubt put some schemes off, but if such a fund is allocated as 10 percent of a growth portfolio, say alongside passive equity, or indeed other return sources, its cost can be easily spread.

Target date funds

Our principle concerns with target date funds is that they do little a lifestyle strategy cannot already do but tie a scheme into a single fund manager where performance is difficult to judge.

In particular, we do not believe tweaking the growth allocation between, say the ages of 25 to 30, serves much purpose, as at both ages an individual is still far off retirement (with a common aim of seeking a long-term, inflation-protected return).

However, these funds can help members manage their transition into retirement. Their flexibility in this phase contrasts lifestyle strategies, where administrators often only allow a single strategy shaping to a single member outcome. Instead, a range of target date funds could allow members to access lump sums and purchase an annuity, while keeping some money invested, all at different target ages.

Engaging millennials

Surveys of millennials often show they are more interested in investments serving a social purpose than previous generations. So the theory runs that placing projects which benefit society into asset allocations could encourage millennials to save more for retirement.

The issue here is that social causes are emotive and what might matter to one individual might not matter to the next. For this reason, a large fund would be needed with a large range of causes for this to really work in terms of scalability.

Another way of engaging millennials could be a rethink of ethical funds. Funds which screen out companies involved in the manufacture of alcohol and armaments have not successfully engaged millennials who are more concerned with corporates that dodge tax. Ethical funds that apply positive screens for companies helping the environment or society might do better.

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