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UK pensions' hedge fund allocations lag behind major EU economies

Among the 12% of UK plan sponsors planning changes to their hedge fund allocations in the next 12 months, virtually all expect to increase them.

Nevertheless, current hedge fund investment in the United Kingdom is much lower than that of institutional investors in other major European economies.

"While the amount invested in hedge funds by UK institutions is up six-fold over the past two years, it still represents only GBP 1.3 billion, or 0.2% of funds' total assets," observes John Webster at Greenwich.

The above trends are revealed in a new report from Greenwich Associates which identifies the major strategic and tactical challenges facing corporate and local authority pension plan sponsors in the United Kingdom.

Despite the strong equity markets of 2003, 25% of UK corporate pension plans have assets covering only 85% or less of their projected benefit obligations.

"UK pension funds find themselves grappling with the sometimes-conflicting demands of low solvency ratios and new regulation," says Greenwich Associates consultant Rodger Smith. "Many are responding by attempting to improve performance in their defined benefit plans by shifting investment approaches, reconfiguring asset allocations, and upgrading investment managers. Over the long term, however, the strategic choice for the majority of corporations will in all likelihood be a switch to defined contribution plans."

Plan Sponsor Strategies

More than 60% of UK plan sponsors tell Greenwich Associates that they plan to make "significant" changes in their asset allocations during the next three years.

While such an aggressive review can be seen to some degree as an effort to address solvency concerns, asset movement within the portfolios of UK pensions during the last five years has been largely one way — out of equities and into fixed interest.

This migration, which has been spurred in part by regulatory changes relating to pension accounting, has resulted in a decrease in UK institutional equity holdings from 73% of total assets in 1999 to just 63% at the end of last year.

Conversely, the proportion of fixed interest in UK pension fund assets has risen from 19% at the end of 1999 to 28% at the end of last year, and is heading north of 30% if plan sponsors follow through on their plans for future shifts.

"Even in 2003, when stock markets generally rose around 30%, equity allocations by U.K. pension funds fell nearly half a percentage point," says Greenwich Associates consultant Rodger Smith. "When property and alternative equities are added in, the ratio is now 70% equity to 30% fixed interest, whereas in the last decade it was more than 80% equity."

Alternative Investments across Europe

Although UK pension plans are lagging behind their European counterparts, another Greenwich survey that examined institutional investment trends across Europe concludes: "One area in which actual Continental institutions' actions have fallen short of past intentions is alternative investments".

"For three years in a row plan sponsors and other institutional executives on the Continent have been saying that they were going to make much more use of this high-alpha class of assets, but when it came time to put the chips down, many lost their nerve," says Chris McNickle.

Despite ambitious projections, European allocations to private equity, which amounted to 1% of total assets in 2003, were virtually unchanged in 2004, and overall allocations to hedge funds also remained flat at roughly 1%.

In hedge funds, moreover, current expectations of Continental institutions appear relatively modest.

"Although those expecting their hedge fund allocations to be higher by 2006 outnumber those expecting the contrary by a wide margin and 23% expect to hire a hedge fund manager in the next 12 months, they are only looking for an annual rate of return of 7.9% over the next five years," says Chris McNickle. "This lags expectations for equity markets."

Investment Manager Turnover

The European survey also indicated that institutional investors have begun to re-shape their rosters of investment managers in order to implement changes in strategy. The result is an unprecedented spate of manager hiring and firing in which the chief beneficiaries are specialty managers and the prime casualties are balanced and multi-product managers.

"What we are seeing across the market is that institutions are re-evaluating their investment strategies and coming to the conclusion that their current managers are not meeting their needs," says Berndt Perl. "So they are terminating these managers — which in many cases were balanced or multi-product firms — and hiring several specialists in their place. Fees for the specialists will be higher than what the institution was spending before, but often higher fees for specialist managers are offset by lower fees paid to passive managers."


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