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Institutional investors “rethink strategy in wake of 2008 losses”

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The typical US institutional investment manager experienced a 31 per cent reduction in portfolio asset values in 2008 with a suddenness that has left investors stunned, according a stud

The typical US institutional investment manager experienced a 31 per cent reduction in portfolio asset values in 2008 with a suddenness that has left investors stunned, according a study from Greenwich Associates.

The 2008 US Investment Management Study says the magnitude of the declines is raising questions about asset allocation decisions, risk management practices, manager selection and overall investment policies used by institutions in the run-up to the market events of the fourth quarter of last year.

Many US institutions have been frustrated by the fact that the broad diversification strategies they have implemented in recent years failed to protect their portfolios from the market downturn.

For the moment, however, most institutions seem to be working from the premise that it is the global financial system that is broken – not their portfolio management policies – and institutions appear committed to diversified investment portfolios including hedge funds and other alternative asset classes. But the dramatic variation in performance among individual hedge funds last year reinforced the critical importance of institutional due diligence capabilities.

The level of due diligence required to assess the people, process and philosophies of both traditional and alternative investment managers can only be achieved with adequate resources and staffing, the study says.

However, the typical US institution employs only two professionals to select and supervise external investment managers – a number that was essentially flat from 2007 to 2008 but is down from the 2.5 average across all institutions in 2006.

Only the largest public and corporate pension plans expanded internal staffing for manager selection and supervision last year, with the average staff among corporate plans with more than USD5bn in assets increasing to 3.4 full time equivalents in 2008 from 2.9 in 2007, and average staffing among public plans with at least USD5bn increasing to 5.8 FTEs from 4.5 FTEs.

‘It is impossible to identify those managers with the skill and consistent, repeatable processes needed for investment success without sophisticated due diligence capabilities,’ says Greenwich Associates consultant Dev Clifford. ‘The real lesson of 2008 is that institutions need to either build up these capabilities in-house, or acquire them externally. Doing without is not an option.’

Three-quarters of institutions rebalanced their investment portfolios last year. However, the study says rebalancing in 2009 will pose some unique challenges.

First, there is the strategic question of whether portfolio managers are willing to take the step when asset values remain at depressed levels and uncertainty around the shape and pace of an eventual economic recovery remains high. Next, even if institutions do decide to stick with their rebalancing policies, some funds might not have the liquidity needed to fully rebalance. 

‘Large volumes of fixed-income assets are essentially still untradable, and many assets that are tradable can be moved only at a painfully deep discount,’ says Greenwich Associates consultant Chris McNickle.

One of the important lessons to come out of the current crisis might well be the value of liquidity – or rather, the dangers of undervaluing it. Prior to the current market collapse, institutions overwhelmingly attempted to minimise the proportion of their assets held in cash, which was seen as a drag on long-term investment performance.

Historically, money market funds and other ‘cash’ investments have made up only a modest portion of institutional investor portfolios, averaging in the neighbourhood of 0.5 per cent of assets.

‘The rapid plunge in asset values quickly demonstrated the value of liquidity, which provides flexibility needed to prevent institutions from having to sell undervalued assets into falling markets in order to fund operations or other needs,’ says Greenwich Associates consultant Rodger Smith.

US endowments and foundations have adopted asset allocations that, in addition to being diversified away from US equities, are also quite aggressive in terms of risk, the report says. Endowments and foundations had the lowest allocations to fixed income of any US institutions in 2008, and much lower allocations than those found among not-for-profits in other countries.

‘At a strategic level, many US endowments and foundations have adopted portfolio strategies that favour the maximisation of long-term investment returns over the preservation of capital as a defining goal,’ says Greenwich Associates consultant William Wechsler. ‘This is not the case in other markets. In Canada, for example, endowments and foundations had approximately half their assets invested in fixed income in 2008; among US endowments and foundations, that share was closer to 20 per cent.’

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