Over the next few years, an increasing number of UK pension scheme members are likely to find their funds invested in diversified growth funds.

These funds, which hold alternative assets such as commodities, property, funds of hedge funds and active currency, as well as equities and fixed income assets, are seen as giving more return bang for the risk buck than standard equity funds.

Diversified growth funds, which could also be called multi-asset funds, can be used in both defined benefit (DB) and defined contribution (DC) pension plans.

In both cases, they aim to produce the returns of an equity fund, but with the volatility of a bond fund.

The growing use of liability-driven investing (LDI) has been a definite factor in the development of diversified growth funds in the UK.

Under LDI, DB schemes should concentrate first on managing interest rate and inflation risk associated with their liabilities, by assembling a liability-matching portfolio of bonds and swaps.

Once this has been done, investment in assets that will match liability growth, with a bit extra for safety, completes the LDI recipe.

In order to reduce equity risk, diversified growth funds have been conceived as a way of producing steady returns over different market conditions.

In addition, these funds aim to produce a return measured against cash returns; this absolute return element is another key difference from long-only equity funds.

So in theory diversified growth funds should produce annual returns of, say, 8-10%, or cash (LIBOR) plus up to 4-5%.

This is less than equities will produce in a good year, but far more than they will in a poor year.

In a DC world, this sort of return is being talked about as good option for default funds, which 90% of DC members end up in.

At present, equities play a role in default funds, especially for younger members, but diversified growth funds could offer more consistent returns.

Not everyone is in agreement with this rapidly developing new paradigm.

Some consultants think a better option would be to ensure DC investments are actively reviewed by trustees to ensure members get good equity returns.

Others wonder how well these funds will be at picking the right underlying investments, or using asset allocation to enhance returns.

Diversified growth funds could well be the next big thing for pension investors.

The next year or so will show if they can deliver what they promise and if scheme trustees like the concept.

The theory sounds fine – will the reality be as attractive?