U.S., Canadian investors hike hedge fund allocations

Date: Monday, September 26, 2005
Author: Arleen Jacobius, Investmentnews.com

LOS ANGELES - North American institutional investors raised their hedge fund allocations this year while decreasing private equity and real estate allocations, according to Tacoma, Wash.-based Russell Investment Group's biennial survey on alternative investing.

Median strategic hedge fund allocations in the United States and Canada increased to 7.7% in 2005, from 7.1% in 2003, while private equity and real estate allocations dropped to 7% and 6.7%, from 7.5% and 7.1%, respectively. This is the first year hedge fund allocations surpassed the other two alternative asset classes.

Much of the increase in hedge funds was driven by the growth in hedge fund allocations, to 6.1% from 2.5%, by public institutions in North America.

North American institutions expected their hedge fund allocation to get even larger by 2007, growing to 9.1% compared with 7.6% in private equity and 7.3% in real estate.

In Europe and Australia, the largest alternative investment allocations will be in real estate. European institutions will increase real estate allocations to 10.5%, from 9.8%, while Australians will decrease their real estate allocations to 9.9%, from 10.4%, by 2007.

But hedge funds are gaining elsewhere in the world, as well. Allocations to the asset class increased to 5.3% from 3.6% in Europe; to 6.2% from 4.3% in Australia; and to 8.1% from 7.1% in Japan.

The survey report noted small response rates for hedge fund questions from Australian investors and private equity questions from investors in Japan in 2003.

"Even with a [negative] headline environment with hedge funds, and questions about whether hedge funds could provide returns, it is an area investors would invest in," said Mark Castelin, director of alternative investments at Russell Investments, in an interview. "Returns are at a reasonable level such as it would be included in their portfolios."

"We did ask why those not investing in hedge funds were not, and the predominant reasons were [that] fees did not justify the risk or lack of transparency," Mr. Castelin said.

New questions on the 2005 survey covered other types of alternative strategies such as currency overlay, portable alpha and tactical asset allocation overlay, he said. Among North American institutions, 30% invest in currency overlay and 26% in timber.

Of survey respondents, 23% used portable alpha, with 44% not currently using the strategy but considering it, and 40% neither using nor considering the strategy. The least used were commodities and absolute-return strategies.

Asked about return expectations through 2007, global investors expected private equity to be the top-performing alternative asset class for the next two years. Japanese investors expected private equity to return 15% through 2007; North Americans and Australians, 12%; and European investors pegged the return at 10.5%.

In real estate, North American investors forecasted an 8.4% return; Australians, 8%; Europeans, 7.5%; and Japanese investors, 5%. Australian investors expected a 10.3% return for hedge funds through 2007; North Americans, 8%; European investors, 6.8%; and Japanese investors, 5%.

Except for Japan, where 83% of assets allocated to alternative investments are in hedge funds, the vast majority of the money committed by global institutional investors is in real estate and private equity. In North America and Europe, hedge funds accounted for only 10% of commitments; in Australia, it's 13%.

However, 53% of North American and 30% of European and Australian commitments are in real estate; and 37% of North American, 60% of European and 57% of Australian alternative commitments are in private equity.

Counter to trends

Running counter to the global trends indicated in the survey, North American endowments and foundations reduced their allocations to private equity, real estate and hedge funds in 2005: Private equity dropped to 9.5% from 14.2%, real estate to 5.8% from 7.9% and hedge funds to 12.8% from 13.7%. However, these institutions expect to increase hedge fund allocations by a little more than a percentage point, to 14%, by 2007.

Overall, more North American investors indicated they intended to increase their percentage allocations to expansion capital, special situations and mezzanine investments rather than to leveraged buyouts. In the 2003 survey, more than 40% of survey respondents indicated they intended to increase their buyout allocations, compared with 19% in 2005. Venture capital stayed about the same, with 27% expecting to increase that allocation, down from 29% in 2003.