New Products and Strategies Shake Up Traditional Asset Allocations

Meanwhile, U.S. 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.

U.S. 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.

Hedge Funds: No Loss of Momentum

Although hedge funds make up slightly more than 2% of U.S. 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 U.S. 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 suggest that institutional use of hedge funds will only grow in coming years,” says Chris McNickle. “Twenty-two percent of U.S. 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.”

Private Equity: Institutions Struggle to Hit Allocation Targets

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.

Greenwich Associates is an international research-based consulting firm in institutional financial services. Greenwich’s studies provide benefits to the buyers and sellers of financial services in the form of benchmark information on best practices and market intelligence on overall trends. Based in Greenwich, Connecticut, with additional offices in London, Toronto, and Tokyo, the firm offers over 100 research-based consulting programs to more than 250 global financial-services companies. Please contact us for further information or to arrange an interview with one of our consultants. You can visit our website, www.greenwich.com, for more information.