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Pension fund allocation to hedge funds continues to grow

A new Mercer survey shows the use of alternative investments continues to increase, in particular active management or so-called 'alpha' strategies.

The preliminary findings of the new survey by Mercer Investment Consulting show:

  • Allocation to bonds remains at 35% while exposure to equities drops 1% to 62% since last year
  • 7% of schemes invest in hedge funds and the same for active currency
  • One in ten schemes is likely to consider introducing a liability-benchmarked investment strategy in 2006.

Alternative investment strategies
The survey shows the use of alternative investments continues to increase, in particular active management or so-called 'alpha' strategies. On average, 7% of schemes now invest in hedge funds and 7% employ an active currency manager. For larger schemes, the figures increase further, with almost 10% investing in hedge funds and around 15% using an active currency manager.

Green commented: "Investment in alternative assets such as hedge funds and active currency is likely to increase further this year, as trustees have become more comfortable with these strategies as a way to diversify risk and enhance performance."

The survey of over 425 UK defined benefit pension schemes with more than GBP 177bn in assets reveals that the average allocation to bonds has increased by just four percentage points in the last three years.

At the same time, pension funds are maturing and the proportion of schemes open to new entrants has fallen to 39% from 42% last year.

Andy Green, Head of Investment Strategy at Mercer, commented: "While it may seem surprising that bond allocations have remained stable at a time when pension schemes are maturing, trustees are concerned about the level of current bond yields and are finding other investment markets more attractive."

The survey shows that the average allocation to equities has dropped only slightly - from 63% in 2005 to 62% this year. Investment in UK equities has decreased from 37% in 2005 to 35% this year, while allocations to overseas equities have risen by one percentage point to 27%.

"Though the UK equity market offers potentially higher dividend yields than other developed markets, stock concentration in the UK means returns are dominated by the performance of a few companies or sectors," Green commented. "Trustees are offsetting the effect of concentration by reducing their exposure to UK stocks and allocating more funds to international equity markets."

Eight per cent of funds have adopted a capped UK equity index benchmark, which limits exposure to the largest stocks, as an alternative way to offset the effect of stock concentration.

The trend towards investing in overseas equities has been supported by an increased use of currency hedging, from 14% of schemes in 2005 to 20% this year. On average, the proportion of currency risk that is hedged is 65%.

According to the survey, less than 4% of schemes still follow a discretionary peer group benchmark strategy. Two-thirds of assets (66%) are invested with active managers, while 34% are invested in track indices.

Liability-benchmarked mandates
The survey also identified that one in ten schemes (10%) is expected to consider introducing some form of cash-flow matching or liability-benchmarked strategy in 2006, either through physical bonds, swaps or liability-driven mandates.

"There is significant interest among pension schemes in managing interest rate risk through liability-benchmarked investment mandates. However, many schemes are finding the current price of long-dated bonds and their derivatives unattractive," said Green.

Mercer will be releasing the full results of its survey on pension fund liability and asset allocation in Europe in April.

For further information and related arrticles on Investing in Hedge Funds, please click here

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