Institutional investor commitment to alternative investments is poised to reach record levels by 2007, according to a new report.
The seventh global report on alternative investing by Russell Investment Group states that investments in hedge funds, private equity and real estate are all forecast to rise. Survey results show hedge fund use continues to increase most dramatically across all regions, and, in Continental Europe, commitment to hedge funds has doubled, as represented by their growing share of overall allocations to alternative investments.
Since 1992, Russell has surveyed the largest tax-exempt institutions (public and corporate pension funds, endowments and foundations generally with assets of USD 3 billion or more) in Europe, the United States, Canada, Japan and Australia to gauge their participation in and expectations for alternative investing.
The results are published in a detailed report, Russell Investment Group Survey on Alternative Investing, which presents data by region, investment category and type of institution; and includes detailed analysis of strategies/investment type used, geographic allocation, and expected returns.
Top-line findings from this year's study include:
• Average strategic allocations to hedge funds, private equity and real estate are expected to rise to new highs by 2007.
• Institutional investors across all geographic regions expect to raise the percentage of their total investment portfolio allocated to alternatives (except in Australia, where respondents anticipate lowering their expected strategic allocation in real estate).
• The number of institutional investors using alternative investments climbed in 2005, particularly due to significant increases in Europe, Australia and Japan.
• Hedge funds have led much of the surge in alternatives, as a growing number of institutional investors use this investment and dedicate an increasing amount of money to this category. Hedge fund use continues to grow dramatically across all regions, particularly outside North America.
• Return expectations are strongest for private equity, as the surveyed institutions across all regions are forecasting well over 10 per cent for this investment category. In contrast, institutional investors in Europe and North America have slightly lowered their forecasts for hedge fund returns even as they add more of these investments to their portfolios.
"While much has been made of redemptions from alternative vehicles in recent months, our survey indicates that contrary to anecdotal evidence, appetite for hedge fund, private equity and real estate is not declining. In fact, institutional investors project that their allocation to all alternative investments will reach record levels by 2007." commented Pascal Duval, Managing Director, Institutional Investment Services, Russell Investment Group. "With changes in retirement demographics and expectations of a low equity return environment, investments once considered fringe are becoming ever more mainstream. European institutions are increasingly seeking out alternative products to boost returns from their 'traditional' investments, reflecting a trend towards return enhancements through the diversification of alpha and beta streams."
"Average strategic allocations to hedge funds, private equity and real estate are forecast to increase to record levels in all regions by 2007, with hedge funds the major beneficiary of this growth."
More details from the survey follow:
1. Compared to 2003, hedge funds have captured a growing share of allocations to alternatives across most regions, particularly in Australia, where they now account for 13 per cent, up from 1 per cent in 2003 Between 2003 and 2005, the percentage of institutional investors using hedge funds grew from 21 per cent to 35 per cent in Europe, from 23 per cent to 27 per cent in North America, from 18 per cent to 32 per cent in Australia and from 41 per cent to 59 per cent in Japan. Funds of hedge funds are by far the most consistently used investment vehicle by European institutions, with the percentage of respondents investing in single and internally managed funds continuing to decrease in 2005, while use of funds of funds continued at a strong 86 per cent rate.
"Investors today do not see hedge funds as a distinct asset class but more accurately as an investment discipline perfectly compatible with 'traditional' fund investing. Given the more stable returns patterns and lower risk profile provided by the intelligent amalgamation of strategies and managers, it is not surprising that the fund of funds approach proved by far the most popular among European institutions," said Duval.
In Europe and North America, hedge funds now account for 10 per cent of the overall allocation to alternatives, roughly double the 6 per cent and 5 per cent levels found in 2003, respectively. By 2007, institutional investors in Europe expect to dedicate 7.2 per cent of their portfolio to hedge funds, an increase from the 5.3 per cent forecast for 2005. Similar changes are anticipated in North America, Australia and Japan, where this figure is forecasted to rise to 9.1 per cent from 7.7 per cent, to 6.6 per cent from 6.2 per cent, and to 11.4 per cent from 8.1 per cent, respectively.
2. Funds of hedge funds have become the investment vehicle of choice for hedge fund allocations. 2005 was the first year the survey asked respondents to which vehicles they allocated hedge fund assets. 74.4 per cent of European hedge fund assets were invested in funds of funds, while 25.5 per cent percent were invested in single funds and a nominal 0.1 per cent was internally managed.
3. Allocations to private equity are forecast to reach new highs in all markets in 2007, with markets that have traditionally had lower allocations to private equity (Europe and Japan) showing the largest expected increases. European tax-exempt institutions currently allocate 4.5 per cent of their investment portfolios to private equity and are planning to increase to 6.1 per cent in 2007. The mean strategic allocation for private equity in Japan stood at 2.4 per cent of total assets in 2005 and is forecast to jump to 4.5 per cent in 2007.
"Institutional investors have an increasing appetite for and willingness to seek out the higher returns that private equity has historically provided, and there is a greater acceptance of the liquidity and risk profiles for this asset class," said Helen Steers, Partner, Pantheon Ventures, Russell Investment Group. "In Europe and Japan, the preferred route for private equity investing is through funds of funds, while in North America and the United Kingdom, the use of single-fund partnerships has increased."
4. Japanese respondents are buying into the established North American private equities market.
Although their total commitment to private equities is currently low - only 2.4 per cent average among respondents - it is expected to nearly double by 2007, with 41 per cent of the total private equity going to North American investments. The increased private equity use in Japan may accelerate in the future due to favorable structuralu and regulatory changes.
5. Real estate represents the largest share of alternative investments in Europe and Australia at 60 per cent and 57 per cent, respectively. In Europe and North America, respondents' use of real estate in allocation strategies remained virtually unchanged since 2003, with 66 per cent of European institutions and 56 per cent of their North American counterparts and investing in real estate.
Institutional investors in all regions except Australia anticipate raising the percentage of their total assets invested in real estate in 2007. For European institutions, these numbers are expected to rise from 9.8 per cent to 10.5 per cent in 2007. In North America and Japan, the forecast rises from 6.7 per cent in 2005 to 7.3 per cent and from 3.4 per cent to 6.1 per cent, respectively. In Australia, the number will dip from, 10.4 per cent to 9.9 per cent.
"While European respondents' capital is overwhelmingly committed in 2005 to direct investments in land and buildings (63 per cent), it is well below 2003's commitment (87 per cent). This decline is chiefly attributable to increased use of core and public real estate securities funds. These provide access to the underlying predictable income stream from property plus, with sound implementation, the ability to source best-of-breed equity managers. Average overall strategic allocations to real estate continued to increase in 2005 to 9.8 per cent, up from 8.3 per cent in 2003, and are expected to exceed 10 per cent by 2007," added Duval.
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