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US pension plans report sharp increase in hedge fund allocations

Hedge fund use by US pension funds, endowments, and foundations remained on a steep upward curve throughout 2003, with 23% of funds reporting hedge fund use as compared to just 12% in the year 2000.

The 2004 US investment management survey by Greenwich Associates indicates that US pension plans' growing allocations to hedge funds is being driven by the search for innovative strategies to keep pace with their growing obligations.

The survey also indicates that US plan sponsors are interviewing and hiring new investment managers at an unprecedented rate.

The recent recovery in global equity markets has failed to alleviate the funding gaps that arose within many US pension plans during the post-bubble bear market. In need of increased returns, institutional investors are trying to squeeze greater returns out of traditional core debt and equity holdings, even as they increase their investments in potentially higher yielding alternative asset classes.

Greenwich Associates consultant Rodger Smith said: "US pension funds are opening their doors to new managers and looking for fresh insights and ideas to a greater extent than we've seen in 30 years of covering this market. They're not abandoning their traditional asset allocations and classes, but they are shopping smarter."

Tweaking the Asset Mix

Although US institutional investors racked up impressive gains during last year's strong equity market performance, these returns have been largely offset by consistently low interest rates, which have the effect of increasing the pension funds' future obligations.

Greenwich Associates consultant John Webster: "At the end of 2002 many pension plans had funding gaps that were becoming increasingly worrisome, and there's little evidence that things have gotten much better."

But plan sponsors are not panicking. Instead, they are sticking with their long-term allocation plans while looking for ways to tweak their current asset mix to provide opportunities for enhanced returns, without taking on significant amounts of risk. To accomplish this goal, they are interviewing and hiring managers at a brisk pace.

Greenwich Associates consultant Dev Clifford said: "Sponsors are looking to these new managers for creative ideas and incremental diversification."

This diversification is taking part within traditional asset classes, as plan sponsors shift to slightly more exotic instruments with marginally higher risks and potentially larger returns. For example, funds are replacing core equities with enhanced index in many portfolios.

In much the same way, plan sponsors are augmenting their traditional bond assignments with global bonds, high yield bonds, and even, to a lesser extent, private placements. Plan sponsors are also replacing some of the basic equities in their international portfolios with slightly riskier stocks in emerging markets offering the possibility of considerably higher rewards.

Hedge Funds

Hedge fund use by US pension funds, endowments, and foundations remained on a steep upward curve throughout 2003, with 23% of funds reporting hedge fund use as compared to just 12% in the year 2000.

The dramatic influx of pension assets into hedge funds is beginning to have profound effects on the asset class. Given the determination of plan sponsors to raise their returns, however, it seems probable that they will overcome any developing concerns.

"Corporate and public pension funds report a 5% average target allocation for hedge funds," says Greenwich consultant Chris McNickle. "If they reached that level, hedge fund investment would total some USD 250 billion, including assets from endowments and foundations. Those levels call into question current hedge fund capacity."

Equity Real Estate

US  pension fund assets invested in equity real estate jumped from USD 175 billion in 2002 to USD 192 billion in 2003 — a figure that is roughly 50% higher than investment levels of the late 1990s.

Within the asset class, plan sponsors are moving into opportunity funds and out of separate portfolios.

Smith said: "There are more plan sponsors investing in equity real estate today, and those that do invest are putting more money into the asset class. As in the case of other asset classes, they are looking for ways to add some degree of risk and, hopefully, increase returns."

Bonus Levels Rebound, Salaries Rise Slightly

For the 686 fund professionals who provided data on their compensation in Greenwich Associates' recent research, average salaries rose some 3%, to just more than USD 130,000 in 2003 from nearly USD 127,000 in 2002. The 43% of fund executives eligible for bonuses saw a more substantial increase, however, with average bonuses jumping 11%, to an expected USD 38,000 in 2003 from just more than USD 34,000 in 2002.

Background Note: Greenwich Associates' 2004 report on the US investment management industry examines these and other steps that plan sponsors are taking amid continued pressure from troublesomely low funding ratios.

The report analyses shifts in asset allocation, including US institutions' increasing use of alternative investments, most notably hedge funds and equity real estate. The report analyzes recent developments in the adoption of cash balance plan structures, and provides detailed data on the compensation levels of US investment professionals.

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