Institutional investors to focus on alternative investments

Date: Tuesday, December 4, 2007
Author: James Langton, Investment Executive

Institutional investors worldwide plan to increase portfolio allocations to alternative investments as they expect private equity returns to increase, with hedge fund and real estate returns remaining steady, according to a new Russell Investments Group survey of institutional investors.

Pension funds, endowments and foundations that responded to a recent survey are forecasting that over the next two years, they will dedicate an even larger slice of their total investment portfolio to private equity, hedge funds and real estate, according to the report.

Institutional respondents around the globe predict that their strategic allocations to hedge funds will increase by 2009, except in Australia where the hedge fund allocation is anticipated to remain steady at 4.1%. European respondents expect allocations to hedge funds to rise to 8.4% from 7.4% while Japanese respondents predict it will increase to 9.9% from 9.3%. The biggest jump is expected in North America, where allocations to hedge funds are forecast to rise to 8.9% from 7.5% over the next two years.

Strategic allocations to private equity by respondents increased in Europe, Australia and Japan and fell slightly in North America. However, all geographic areas forecast allocation increases through 2009.

Across the globe, respondents' return expectations are strongest for private equity, with expectations for hedge funds and real estate remaining steady. Mean return expectations for private equity worldwide vary between 8% and 13%, with North American and European respondents expressing the greatest optimism for performance of this asset class.

The utilization of real estate as an investment strategy climbed worldwide over the past two years, particularly in Japan where utilization rose from only one in five respondents in 2005 to almost 40% this year.

“Describing the use of private equity, hedge funds and real estate as ‘alternative’ is increasingly a misnomer in today’s sophisticated investment environment. Russell’s survey highlights systematic use of these strategies to enhance returns, reduce volatility and improve fund governance through diversification,” said Jon Bailie, managing director, alternative investments, for Russell. “Fund of funds remain the preferred route to access both private equity and hedge funds, with limited in-house investment resources dedicated to these strategies by even the world’s largest institutions. With outsourcing gaining traction across the globe, consultants continue to have an important role to play.”

Hedge fund use among the respondents is most widespread in Japan - the percentage of respondents investing in hedge funds increased to 71% in 2007 from 59% in 2005. Hedge funds now make up more than 9% of the mean strategic allocation for institutional investors surveyed in Japan. Conversely, Japanese expect hedge funds to return only 4.6% on average through 2009, while institutional investors in United States, Europe and Australia all expect hedge funds to return about 9%.

"Worldwide, hedge funds have matured as an investment tool for diversifying portfolios and reducing risk," said Victor Leverett, director, hedge funds, Russell Investments. "As more and more players enter the hedge fund marketplace, institutional investors are turning to consultants to help them select hedge fund providers and better understand the esoteric strategies they often employ. Consultant use rose by 25 percentage points from the last survey in North America, 32 in Australia and 20 in Japan while remaining stable in Europe."

Leveraged buyouts remained the most popular private equity strategy across the world among survey respondents and increased in commitments across all regions, except for a slight decline in Europe. The strategy dominates in North America, representing 71% of private equity commitments in 2007 and a substantial increase from 57% in 2005. Australia and Japan saw similar leaps in commitments to leveraged buyouts, over the same time. In Europe, commitments to expansion capital increased to 12% from 6%, while commitments to mezzanine financing and other types of private equity investment, including secondaries and special situations, fell to 11% from 15%.

“The private equity community witnessed enormous volumes of LBO activity over the past two years, but investors may have come to the conclusion that the best and biggest buyouts have already occurred,” said Jay Pierrepont, managing partner, Pantheon Ventures-Russell Investments. “Institutional investors still have high expectations for private equity and are forecasting, with the exception of Japanese respondents’ expectations for 2007 and 2008, double-digit returns, for the next two years derived predominately from venture capital and secondary opportunities.”

Strategic allocations to real estate are forecast to increase in all regions over the next two years. In North America, institutional investors anticipate their strategic allocation will increase to 7.3% in 2009 from 6.7% in 2007. European respondents expect strategic allocation to real estate to rise to 9.7% from 8.9%. Australian respondents anticipate a rise to 10.5% from 9.6%, and Japanese respondents' mean strategic asset allocation to real estate is expected to increase to 5.7% from 4.7%.

“Real estate continues to play an integral role in institutional portfolios,” said Karl Smith, director, real estate, Russell Investments. “Respondents around the world plan to increase allocations through 2009, with many respondents expressing interest in globally diversified real estate investments with access through private real estate funds and more liquid publicly traded real estate securities (REITs).”

Worldwide, respondents continue to explore new strategies to add to the alternative investment mix beyond hedge funds, private equity and real estate. Many European respondents are either using or considering other forms of alternative investing. Among strategies currently being employed, currency overlay, absolute return and infrastructure were mentioned most frequently. Among strategies actively being considered, currency overlay, tactical asset allocation, portable alpha and infrastructure were most frequently mentioned.