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J.P. Morgan Asset Management’s Annabel Tonry discusses how DC schemes can gain exposure to different asset classes in a low-return environment

WELCOME

So far, DC plans have largely been focused on the onset of auto-enrolment and changes to the regulatory framework – be it the ‘charge cap,’ ‘pension freedoms’ or consultations around ‘value for money’, says Annabel Tonry, Executive Director at J.P. Morgan Asset Management (JPMAM). But we are now starting to see a shift. In this guide Tonry discusses why schemes should allocate across a broad set of asset classes and how, in a challenging return environment, actively managed strategies can deliver much needed alpha.

THE INTERVIEW

Why DC schemes should take a flexible approach in a low-return environment

Annabel Tonry,

Executive Director, UK Defined Contribution

What investment strategies should DC schemes be considering?

DB plans have been investing in multi-asset credit for years. They achieve fixed income returns by looking at strategies with a higher allocation to investment grade credit, and by seeking out ‘unconstrained ways’ of investing in fixed income. So DC schemes should be thinking about how they can invest in fixed income in the growth phase to boost risk-adjusted returns, not just at the end of the ‘glide path’ before you reach retirement. If you look at the US market, they have a regulation that states your default ‘glide path’ must be diversified across asset classes at all points. The other trend we see today relates to alternative risk premia. DC schemes often have an allocation of 100% global equities in the growth phase so they are starting to think about how they can diversify that allocation. That’s why we’re starting to see an interest in alternative beta or more alternative risk premia strategies. They are cost efficient, their strategies provide daily liquidity and they have a low correlation to equities.

In a challenging return environment, investing across multiple different asset classes can help overcome the limitations of a traditional portfolio. We spoke to Annabel Tonry, client adviser for UK defined contribution at J.P. Morgan Asset Management, about why DC schemes should take a flexible approach and allocate across a broad set of asset classes to enhance returns, while still keeping a lid on costs.

In today’s low growth environment how can default funds adapt to ensure members get the best outcomes at retirement?

It is critical DC schemes think about having a well-designed robust default fund, so that members are encouraged to try and save as much as they possibly can. Diversification is important, as is employing active management. Even a small amount of additional alpha via active asset allocation decisions or security selection each year – 50 basis points, for example – can make a huge difference to somebody when they retire and that sum has been compounded over 30 or 40-plus years. In a low growth environment, these are the key things default funds should be focusing on.

Can Environmental Social Governance (ESG) help drive value for DC scheme members?

We have started to see a growing interest in ESG from the DC industry, however, I think there’s still a relatively low level of understanding around what ESG is, how it’s defined, its applicability and what it can mean for your investment return. The requirement on trustees now is they do need to consider ESG factors, at least on a very basic level, and its impact upon long-term returns and I would expect to see increasing interest from DC plans.

What do you see as the principal risks of a purely passive approach?

First, we should acknowledge that the passive approach has ‘pros’ and ‘cons’. We begin by talking to our clients about their objectives, then we think about which asset classes they will need in order to meet this objective. Next we think about how these are going to be implemented, whether actively or passively. We believe it’s a complement of both and clearly passive allocations can help reduce costs for DC plans. A purely passive approach could be quite volatile, depending on the market conditions and it could potentially limit your diversification, depending on the type of asset class that’s being considered. Furthermore, particular sectors may carry more risk and active management can add significant value. We also have to consider that a passive approach will always underperform the benchmark net of fees. In an environment where returns are likely to remain low, the additional alpha that you get from an actively managed strategy can make a meaningful difference, especially when compounded over the lifetime of a DC saver.

To what extent are DC defaults currently pursuing a low cost approach at the expense of value of money?

It’s fair to say we have seen an impact following the introduction of the ‘charge cap’. Subsequently, a lot of DC schemes have become very focused on cost and imagining the lowest cost to mean: ‘I’ve got the best possible deal’. This doesn’t apply to all DC schemes but we have definitely seen a shift, with plans starting with price, rather than starting with an objective. It’s important to make sure that trustees are still enabled to make the right investment decisions and don’t feel concerned about, for example, increasing fees within the charge cap if they believe it’s in the interest of members to do so.

An increasing number of DC schemes are expressing dissatisfaction with diversified growth funds (DGFs). Is this a mistake?

We believe so. There has been a lot of dissatisfaction across the board with diversified growth funds. Unfortunately or fortunately, the DGFs universe is not a homogenous universe. Encapsulated under diversified growth is a whole array of different strategies, from core diversified growth funds to more idiosyncratic absolute return DGFs. And they have performed quite differently over the past five years. For DC schemes that are hindered by cost pressures, a DGF is a fantastic way to access diversification and get exposure to different asset classes – be that private equity or infrastructure, for example. It’s also worth remembering why diversified growth funds have been put in place. They are designed to have similar returns to equities but with a lot less volatility. A lot of these DGFs, particularly within DC, were included to help members achieve a risk-adjusted return but with reduced volatility.

DC investment strategies are seen, by and large, as unsophisticated. What lessons can DC strategies learn from DB schemes?

The single biggest lesson DC schemes can learn from DB plans is the value of diversification and the need to consider more esoteric asset classes. A lot of advisers want access to different risk premia or different ways of investing, but have been hindered to date through restrictions like liquidity or cost. While most DC plans have understandably been focused on the onset of auto-enrolment and changes to the regulatory framework – be it the ‘charge cap,’ ‘pension freedoms’ or consultations around ‘value for money’ – we are now starting to see a shift.

Risk profiling

NEED TO KNOW

What can DC schemes do to improve members’ retirement outcomes?

Source: J.P. Morgan Asset Management estimates as of 30 September 2016 and 30 September 2017. Forecasts are not a reliable indicator of future performance.

3. Employ active management

1. Encourage greater savings

2. Focus on diversification

The long-term outlook for capital markets rarely changes dramatically over a single year, and pension schemes have little influence over its course. However, JPMAM sees potential for technology-induced productivity improvements to help end a prolonged series of downgrades to trend growth. Nevertheless, investors can still expect to face a historically low return environment over the next decade. According to JPMAM, here are three concrete steps schemes can take to help improve members’ retirement outcomes. Members need to save more and start early. Our latest long-term economic growth and market return assumptions (LTCMA), combined with longer life expectancy, validate members’ concerns about the possibility of outliving their retirement savings. Saving more is the most obvious and effective way to improve retirement outcomes. We believe the best approach to encouraging saving is to have a robust, well-designed default fund that allows members to focus on their savings levels rather than worrying about how to invest their assets. We know that sharp declines in the size of savings pots can cause members to reduce savings rates—or stop saving altogether. Steadier, more consistent returns are therefore vital in encouraging members to stay the course. With the minimum level of automatic enrolment contributions going up in April 2018, generally for both employers and employees, qualified schemes will need to make sure members don’t opt out. Member communication will continue to be a top priority and should emphasise the benefits of saving early, saving regularly and saving enough. Return estimates for a simple 60%/40% stock-bond portfolio remain subdued. But, as seen in the graph opposite, there are a number of asset classes clustering close to and even lying above the stock-bond frontier, implying opportunity for diversification and potential return enhancement. Diversified growth funds (DGFs) are one approach DC schemes have used to help diversify their default funds cost-effectively. Now we are also starting to see DC schemes incorporate strategies into their default funds that traditionally have been used by defined benefit (DB) schemes, to help mitigate downside risk without compromising returns. These include multi-asset credit strategies, which can offer access to high conviction ideas across the credit spectrum. Another example: alternative risk premia strategies, designed to provide some of the diversification benefits of common hedge fund strategies but with increased transparency and liquidity—and generally without hedge-fund-like fees.

Keep in mind that there are two components of return: the portion due to the market itself (beta) and the portion resulting from active manager skill (alpha). Our LTCMA, by design, do not reflect returns from active management; they are estimates of index-based (or beta) returns, intended to inform strategic allocation decisions over a 10 to 15-year investment horizon. With a lower outlook for beta returns across most asset classes, alpha becomes an even more critical component for achieving required returns. Skilled professional investors can generate alpha through adept security selection and/or active asset allocation — opportunistically shifting exposures across sectors, asset classes and regions as attractive opportunities present themselves. For example, insights into tangible investment opportunities associated with technological change (see our 2018 LTCMA), and the ability to tactically position portfolios through the late-cycle challenges ahead, present opportunities for alpha generation. And given the low correlation between the alpha and beta components of return, the active component can also help to diversify portfolio risk.

FUND STRATEGIES

In profile: Diversified Growth; Flexible Credit; Alternative Beta

Source: J.P. Morgan Asset Management. For illustrative purposes only. FX = Foreign exchange. Diversification does not guarantee investment returns and does not eliminate the risk of loss.

Source: J.P. Morgan Asset Management, Bloomberg. Analysis period: January 2003 to December 2017. For illustrative purposes only. Performance calculation is simulated and no guarantee is given that the portfolio will perform accordingly (as based also on other factors that may not be part of the simulation). Past performance is not a reliable indicator of current and future results. All returns are total returns in USD, gross of fees.

JPMorgan Life Diversified Alternative Beta Fund

Investment approach: The Fund seeks to provide a total return in excess of its cash benchmark by exploiting behavioural patterns in the financial markets, primarily through the use of financial derivative instruments. The Fund also accesses alternative risk premia which provides comparatively lower cost, greater liquidity and greater transparency than traditional hedge fund structures. Fund exposure: The Fund has a blend of lowly correlated strategies including Equity Long/Short (market-neutral), Macro/Managed Futures, Event-Driven and Convertible Arbitrage. The Fund may invest in funds which use derivatives for investment purposes. The Fund may also use derivatives for efficient portfolio management or the reduction of investment risk. Management style: The J.P. Morgan Asset Management Quantitative Beta Strategies Team is one of the longest-established managers of alternative beta strategies, with an eight-year track record. The portfolio managers are: Yazann Romahi, Wei Victor Lei and Jonathan Msika and they aim to capture returns from alternative strategies. The strategy works by isolating the non-manager driven component returns from four alternative strategies: macro/managed futures, equity market neutral, event-driven and convertible bond arbitrage. Using four different, uncorrelated strategies enables the strategy to achieve a more diversified return profile, which can help to reduce risk. The strategic allocation is based on equal risk exposures to the three main hedge fund styles, with convertible bond arbitrage grouped alongside event-driven strategies. In the short term, the allocations are dynamic, reflecting the opportunity within each individual style.

Source: J.P. Morgan Asset Management © Morningstar. All Rights Reserved as at 31.12.2017. Past performance is not a reliable indicator of current and future results. Strategy returns are shown gross of fees.

Source: J.P. Morgan Asset Management

JPMorgan Funds – Flexible Credit Fund

Investment approach: By providing access to attractive returns relative to broad fixed income and mitigating downside risks compared to equities, an allocation to credit may be particularly attractive for DC plans looking to diversify passive equity exposure in growth-phase default portfolios. The JPMorgan Funds – Flexible Credit Fund is a benchmark agnostic portfolio that aims to maximise the “credit” portion of total returns by dynamically allocating to high conviction credit ideas throughout a market cycle. Furthermore, the fund places a strong emphasis on limiting downside and smoothing the investment journey through diversification, flexible positioning and hedging strategies. Fund exposure: The fund targets a total return by exploiting investment opportunities in credit markets globally utilising an investment process that incorporates both top down and bottom up inputs. It invests in a range of sectors and geographical regions. The fund’s opportunity set consists of investment grade, high yield and emerging corporate bonds. Management style: The fund is headed up by lead portfolio manager, Lisa Coleman, who has 35 years of experience managing credit and unconstrained portfolios. The other members of the portfolio management team include: Usman Naeem, Andreas Michalitsianos and Alexander Sammarco. The fund has delivered annualised returns within 5% +/-2% target range since inception (gross of fees), with half the volatility of the broader high yield market, while limiting downside risk relative to other parts of the market. The fund follows an investment process that is both top down and bottom up. Top down inputs help the named portfolio managers determine the asset allocation across the opportunity set and actively shift this allocation to respond to their evolving investment themes within credit. The bottom up component of the process is driven by a globally based team of 59 credit research analysts who specialize in specific sectors within their respective asset classes.

Source: Mercer Insights as at 31.12.2017. Past performance is not an indication of current and future performance. The fee of 30 basis points TER, will be applied to all investments made until the fund reaches £500 million and will last for the lifetime of each investment. Annualised returns are shown gross of fees.

Source: J.P Morgan Asset Management March 2017

JPMorgan Life Diversified Growth Fund

Investment approach: The JPMorgan Life Diversified Growth Fund is managed by multi-asset experts and aims to achieve long-term term capital growth by investing directly or indirectly in a diversified mix of asset classes. The fund is designed for the DC journey and is underpinned by an active investment approach within a robust risk framework. Fund exposure: In a single fund, investors gain exposure to several asset classes chosen specifically for their high-return potential and low correlation. An active asset allocation around the fund’s strategic allocation (see below) gives the managers the flexibility to take advantage of opportunities when they arise and to be more defensive in periods of uncertainty. Management style: The fund is managed by a team of three highly experienced managers in multi-asset solutions. They are Katy Thorneycroft, Joe Cummings and Pete Malone. The team draws on the breadth and depth of the fund platform at JPMAM, across asset classes, geographies and styles. The fund’s managers can also use third-party investment trusts, drawing on the portfolio management team’s considerable expertise in researching these vehicles. To manage portfolio risk and implement shorter-term asset class, regional and country-level views, the fund may use derivatives. The fund can also use exchange-traded funds.

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