Greenwich Research: New products and alternative strategies shake up "traditional" asset allocations for US institutions

US pension funds and endowments continue to shift assets out of domestic stock investments and into hedge funds, private equity and international equities, according to new research from Greenwich Associates.

Private equity investments made up 3.8% of US institutional assets in 2006, up from 3.6% in 2005. Over the same period, hedge funds grew to 2.1% of total assets from 1.9%. "The growth in international equity was even more pronounced," says Greenwich Associates consultant Dev Clifford. "Thanks in large part to the superior performance of international stocks relative to other investments last year, average institutional allocations to international equities increased to 15% from 13.9% over the 12-month period."

Meanwhile, US institutions are cutting allocations to domestic equities. Average allocations to domestic stocks declined to 44.7% of total assets in 2006 from 46.7% in 2005. Fixed income allocations, while essentially unchanged from year to year, are down nearly 5% from 2002 levels. "Based on plan sponsors' expectations for future changes, there is every reason to believe that allocations to fixed income and domestic equity will continue to decline," says Greenwich Associates consultant Chris McNickle.

US institutions expect international equities, hedge funds, private equity and equity real estate to outperform domestic stocks on an annual basis over the next five years. "In particular, institutions expect international stocks to outperform domestic equities by an annual 140 basis points," says Greenwich Associates consultant Rodger Smith.

Although hedge funds make up slightly more than 2% of US institutional assets on an overall average basis, allocations are much higher when the analysis is restricted to institutions that actively invest in the asset class. "In both hedge funds and private equity, allocations among active investors exceed the 5% of total assets generally considered necessary to achieve a meaningful positive or negative impact on the overall portfolio," says Greenwich Associates consultant Will Wechsler.

The proportion of US institutions investing in hedge funds has been rising steadily over the past three years, increasing to 36% in 2006 from 32% in 2005 and 29% in 2004. As one would expect, endowments are the biggest USers, with 75% reporting that they invest in hedge funds. Nearly a quarter of corporate plan sponsors say they invest in hedge funds, up from 21% in 2005 and 19% in 2004. Public plan sponsor USe of hedge funds increased slightly to 23% in 2006 from 22% in 2005, despite a falloff in allocations.

"The data suggests that institutional USe of hedge funds will only grow in coming years," says Chris McNickle. "Twenty-two percent of US funds expect to make significant increases to hedge fund allocations by 2009. Among public pension funds, more than 42% are planning significant increases to their hedge fund allocations."

Although institutional allocations to private equity increased from 2005 to 2006, private equity remains a "chronically underinvested" asset class, according to Will Wechsler. He explains: "Increasing actual allocations to target levels has proved a difficult task for most institutions. There is a lack of capacity relative to the amount of capital institutions would like to devote to the asset class, and where capacity does exist, it is generally outside of the relatively small number of fund managers that have historically generated the best and most consistent returns."

This problem seems particularly acute for public and corporate plan sponsors, which in 2006 reported average private equity allocations of 4.3% and 2.5%, respectively. Endowments, by comparison, reported average allocations of 8.4% of total assets. Reflecting these difficulties, more than a third of funds say they expect to significantly increase their exposure to private equity over the next three years - a proportion substantially higher than that found in any other asset class.

As part of its most recent asset allocation research, Greenwich Associates interviewed 219 public pension plan sponsors, 578 corporate plan sponsors and 266 endowments and foundations. Interviews were conducted from AugUSt to October, 2006. The report released this week provides detailed information on the asset allocation strategies of public and corporate plan sponsors, endowments and foundations, as well as data and analysis related to institutional investment practices in individual traditional and alternative asset classes.

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