Institutional investors switching from U.S. equities

U.S. institutional investors are increasing the share of their assets invested in international equities, private equity, and other alternative asset classes, according to new research from Greenwich Associates.

Greenwich notes that the shifts into these investments have been funded in past months by moving assets out of fixed-income, but its research suggests that US equities could be next to take a hit.

Among all U.S. pension funds, endowments and foundations, the share of total assets invested in domestic equities remained essentially flat from 2004 to 2005, despite positive market performance, it noted. Looking ahead, 17% of U.S funds expect to make a “significant” decrease to their allocations of active domestic stocks in the next three years, and 20% plan to make similar reductions to passive equity allocations.

If U.S. institutions follow through with their plans to cut domestic equity allocations, international stocks appear poised to be one of the main beneficiaries, Greenwich reported. “Active international equity allocations among U.S. institutions increased by 0.5% from 10% of total assets in 2004 to 10.5% in 2005 as funds looked to capitalize on their expectations that returns on international stocks will continue to outpace those of domestic equities,” it said. And, this trend appears likely to continue, it said, noting that 10% of U.S. corporate funds expect to make “significant” increases to their active international equity allocations in the next three years, as do 9% of public funds and more than 20% of endowments.

Equity real estate will also be a potential recipient, Greenwich suggested. Among all US institutions, equity real estate allocations have increased from 3.1% of total assets in 2001 to 3.9% in 2005; 36% of endowments plan to make a significant increase to their equity real estate holdings over the next three years, as do 29% of public funds and 23% of corporate pension funds.

“At a time when many funds are looking for more predictable, less volatile returns, real estate has a lot of attractions,” says Greenwich Associates consultant Lea Hansen, “including a more stable stream of income, the chance to participate in an improving economy, and a lack of correlation with other asset categories.”

Whether funds’ expectations will be met is harder to say. “Real estate is a cyclical phenomenon and it’s hard to find anyone who thinks that this market is not close to a peak,” says Greenwich Associates consultant Rodger Smith. “One sign that the market has become red-hot is the increasing difficulty that funds are having getting into desired investments; most open ended funds have queues of investors waiting to get in.”

Institutions might have similar difficulties putting their money to work in another red-hot asset class, private equity, Greenwich cautioned. In 2005, private equity made up 8.9% of the assets of U.S. endowments and constituted 4.0% of public pension assets and 2.3% of corporate plan assets. Looking out over the next three years, Greenwich Associates data show that 30% of corporate pension plans, 41% of public plans and 48% of endowments are planning to make “significant” increases to their private equity allocations.

“U.S. funds report that they expect private equity to return 11.3% annually for the next five years,” says Greenwich Associates consultant Dev Clifford. “That expected ROR is the highest of any asset class and is sure to sustain strong demand for the foreseeable future.”

As with real estate however, the opportunities to invest in private equity may be somewhat limited. “At least on the venture side, there are a very small number of firms that consistently generate superior returns,” notes Greenwich Associates consultant John Webster. “New investors are unlikely to get the opportunity to invest directly in funds offered by these firms and will instead often have to rely on funds-of-funds for access.”

Although all types of fund have reduced their expected rates of return on hedge funds, their diversification benefits and the potential stable returns with less downside continue to attract institutional investment dollars, the firm noted. “Although corporate hedge fund allocations were unchanged at 0.9% of assets from 2004 to 2005 and public allocations rose only slightly from 0.6% to 0.7%, all indications suggest that institutional investment in hedge funds will continue to grow,” says Greenwich Associates consultant William Wechsler. “Specifically, 34% of U.S. pensions and endowments expect to make significant new commitments to hedge fund allocations in the next three years.”