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US institutions opt for international equities and alternative investment

US institutional investors are looking to bridge the gap between expected returns and future funding needs with international equities and alternative investment.

New research from Greenwich Associates reveals that US public and private pension plan sponsors, endowments and foundations reduced their average fixed-income holdings from 26.8 per cent of total portfolio assets in 2003 to 23.7 per cent in 2004 signifying a shift into investments with the potential to deliver more robust returns. During that period, US funds kept allocations to domestic stocks roughly stable at approximately 47 per cent of plan assets - a level that is much reduced from the more than 52 per cent reported in 2000 and which could fall further if plan sponsors follow through with current plans.

As Greenwich Associates consultant Dev Clifford explains: "Twelve per cent of US plan sponsors tell Greenwich Associates that they expect to make significant cuts to their actively managed US equities over the next three years, and another 13 per cent plan cuts in passive domestic equities."

These observations are based on Greenwich Associates' 2005 US Asset Allocation research, for which Greenwich conducted in-person interviews with fund professionals at 610 corporate funds, 242 public funds, and 235 endowments and foundations. A new Greenwich Associates report presents the key findings of this research, which reveals that US funds are relying in large part on investment returns to address a serious challenge in funding and solvency ratios that remain persistently low despite two years of relatively strong market performance.

Rate-of-return expectations falling

US funds decreased their expected rates of returns on all major asset classes from 2003 to 2004. The average annual rate of return expected by US institutional investors from fixed income over the next five years fell sharply from 5.9 per cent in 2002 to 4.9 per cent in 2004. Average domestic equity return expectations among US funds dropped from 8.2 per cent to 8.1 per cent over the same period. Average return expectations also fell for equity real estate and private equity, with expected returns on equity real estate dropping from 8.2 per cent in 2003 to 8.1 per cent in 2004, and the average expected rates of return on private equity fell from 11.3 per cent to 11.1 per cent. Endowments dropped their five-year annual return expectations for hedge funds from 9.2 per cent in 2003 to just 8.4 per cent in 2004, while public funds lowered their hedge fund expectations from 9.2 per cent to 8.5 per cent and corporate hedge fund expectations fell from 9.1 per cent to 9 per cent.

Asset Allocation Trends

Among US institutional investors, international equity holdings grew from slightly more than 11 per cent of total fund assets in 2003 to more than 13 per cent in 2004. At the same time, hedge fund allocations grew to 1.6 per cent of plan assets over the past 12 months. However, despite the reported decrease in expected rates-of-return on hedge funds, the consultants at Greenwich Associates believe that hedge fund investments will remain on its current trajectory of cautious growth, due to the return advantage that the asset class offers over other investment options, and the additional benefits promised by hedge funds.

In equity real estate, allocations increased from 3.6 per cent to 3.8 per cent of total plan assets. At the same time, institutional allocations to private equity increased from 3 per cent to 3.4 per cent of total assets from 2003 to 2004, and Greenwich Associates research suggests that additional growth could be ahead.

Plans For the Future

Where do US funds expect to invest in the next three years? According to the survey, the answer is simple: alternative asset classes. More than a third of US institutional investors expect to make a significant increase to hedge funds in the next three years, while another 30 per cent plan sizable additions to private equity, and almost a quarter plan similar increases to their equity real estate.

Greenwich Associates' research suggests that the assets funding these increases will come largely from core asset classes. Between 12 per cent and 13 per cent of US funds expect to make a significant decrease to domestic equities in the next three years, and another 12 per cent plan to cut allocations to passive international stocks. In addition, one-in-10 US funds plan to make meaningful cuts to their fixed-income allocations in the same period.

"Of course, it is important to view these expectations with some degree of caution," notes Greenwich Associates consultant William Wechsler. "Despite several years in which pension plan sponsors have predicted meaningful increases in their hedge fund activity, hedge fund allocations have only increased from 1.0 per cent of total assets to 1.6 per cent from 2002 to 2004."

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