Alternative investments are a "permanent fixture" in institutional portfolios: Growing appetite for separating alpha and beta returns

A new study by State Street reveals that hedge funds have shed their 'niche' status and are a firm part of the US institutional allocation process.

Gary Enos, executive vice president and head of State Street's alternative investment servicing business, said: 'All signs indicate that what began as a niche category catering mainly to high-net worth individuals and US endowments and foundations has become a permanent fixture within a broader set of institutional portfolios,'

He added: 'Satisfied customers go a long way towards explaining the industry's proliferation. Our study reveals hedge funds are meeting institutional investors' expectations with an astounding 100 per cent satisfaction rate in achieving portfolio diversification as well as high marks for lowering portfolio volatility and increasing absolute return.'

State Street Corporation's second institutional investor hedge fund study was released yesterday. State Street conducted the study late last year in conjunction with the 2005 Global Absolute Return Congress (Global ARC). Survey respondents included global corporate pensions (18 per cent), public and government pensions (42 per cent) and endowments and foundations (40 per cent) with investable assets totaling more than USD 1 trillion.

According to the study, most investment boards and trustees of institutions (81 percent) have become more comfortable with investing in hedge funds in the past year, and the majority (52 per cent) of these governing bodies spend 15 per cent or more of their time discussing alternative investments. The survey also found that most institutions intend to add new hedge fund and private equity managers to their current manager line-up in the coming year.

Shift away from mainstream investments

This year's survey shows a marked shift away from mainstream investments. Of the institutions who indicated they were making increased allocations to hedge funds, 45% were allocating away from active equities, 35% from passive equities, 5% from active bonds, 10% from passive bonds, and, interestingly, 5% from commodities.

On the private equity front, 59% were allocating away from active equities, 22% from passive equities, 5% from active bonds, 5% from passive bonds, and 9% from hedge funds, funds of hedge funds, or hedge funds indices.

Increase in Hedge Fund and Private Equity Allocations

According to the State Street study, nearly half (48 per cent) of respondents have 5 per cent or more of their portfolios invested in hedge funds today. Of this figure, most (44 per cent) have 10 per cent or more invested in hedge funds. This represents an increase over 2004, when only 35 per cent of institutions said they had 10 per cent or more invested in hedge funds.

For the first time, State Street also surveyed respondents about the role of private equity in their portfolios. Ninety per cent of respondents allocate to private equity. Nearly half (47 per cent) allocated 5 per cent or more to this strategy. Nineteen per cent said they allocate 10 percent or more.

Adding Alternative Investment Managers

Institutional investors who participated in State Street's study also indicated that they have plans to hire new alternative investment managers in the coming year. Eighty-six per cent of respondents said they plan to add new hedge fund managers to their current line-up, while 67 per cent said their hiring plans included new private equity managers.

Separating 'Alpha' and 'Beta' Returns

The results of State Street's study also illustrate institutional investors' growing appetite for separating asset class returns, or beta, and absolute returns, or alpha.  By disaggregating risk into 'alpha' and 'beta' strategies, institutions can better tailor portfolios to fit their specific investment objectives. Eighty-one per cent of survey respondents said they engaged new managers for both alpha and beta returns, and a majority (59 per cent) said they were able to differentiate between a given manager's 'alpha' and 'beta' results. Among those who said they could not differentiate (41 percent), an overwhelming majority (82 per cent) attributed this inability to a lack of tools and/or resources.

'As investors become more aware of the benefits of separating alpha and beta, asset managers who can provide a wide range of beta exposures and interchangeable alpha sources are uniquely positioned,' said Jane Tisdale, managing director of hedge fund strategies for State Street Global Advisors, the investment management arm of State Street Corporation. 'Access to customizable resources such as alpha porting techniques offer increased transparency in measuring and rewarding performance and allow the flexibility to increase portfolio diversification with a low tracking error.'

The survey also confirms the trend in the US market towards the MAC (Mutli asset class) investing approach. Early this week in the UK, leading pension consultant Roger Urwin at Watson Wyatt called for a new approach to UK pension fund investing, away from a concentration in equities and towards broadly diversified portfolios.

In an article in this week's edition of Hedgeweek, Guy Fraser-Sampson, argues the case for European institutions taking the MAC approach.

A pdf of the State Street study's key findings can be downloaded - please click here

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