Institutional investors that experiment with small allocations to private equity, hedge funds, and real estate might be taking on new cost and complexity with little chance of a meaningful return, says Greenwich Associates.
“Dabbling in alternatives demands a disproportionate amount of resources for monitoring and managing,” says Greenwich Associates consultant Rodger Smith. “There is little hope of justifying that effort without more substantial allocations. These investments can be very helpful in diversifying portfolio risk and can have a meaningful impact on portfolio returns, but investors will want to consider working with them more aggressively. Very large funds have the resources to do this, but mid-size funds may need outside help and will benefit from fund-of-funds structures.”
At allocation levels reported by global institutional investors in Greenwich Associates’ 2003 research, even better-than-expected returns from the alternative investments made thus far by most institutions will have only a minimal impact on the risks and returns of a fund’s total portfolio.
Global institutional allocations to alternative investments increased by about 1% last year, with institutions in Australia and Canada leading the way at 14% and 10% of overall portfolios, respectively. Despite this worldwide growth, however, the consultants at Greenwich Associates observe that many funds remain at allocations far below levels at which they will have a bearing on overall returns. Presently, endowments and foundations in the United States represent the only category of funds in the world that have surpassed this threshold, with average allocations of 20% in 2002, up from 16.3% the year before.
“If your goal isn’t to get private equity and hedge fund allocations in your portfolio to at least 10% – and 15% is even better – then know your plan to get there, or don’t go there at all,” says Greenwich Associates consultant Chris McNickle. “Without a significant minimum allocation, it will be impossible to fully benefit from diversification. Alternatives are a great tool, but they are not for everybody.”
In last year’s research, 40% of US pension funds reported using private equity in their portfolios – the highest in any market, followed by about one-third of investors in Australia and Europe. (2004 results will be available from Greenwich Associates in February.) British and Canadian usage is lower, with approximately one in seven pension funds using the instruments, while private equity is almost non-existent in Japan. Greenwich’s consultants remind potential private equity investors that, generally, only the top 25 private equity funds generate better returns than the S&P. With that in mind, gaining access to and investing in the right fund is key to success in the asset class.
United States, European, and Canadian pension funds all reported that about 1% of portfolio assets were invested in hedge funds last year. In the United States, this allocation totaled just $50 billion, although that figure represents a significant jump from the $32 billion invested the year before. As with private equity, European allocations to hedge funds have increased significantly, to $8 billion in 2003 from $3 billion in 2002. In both the United Kingdom and Japan, pension funds directed an additional $1 billion dollars to hedge fund investments last year.
Real estate allocations are highest in Australia, at 10.2%. Year-on-year increases in the United Kingdom, continental Europe, and Canada are evident in this year’s reported allocations, and the asset class now accounts for about 6% of average portfolios in each of these markets. U.S. pension fund allocations to real estate are the lowest, at 3.4%, but are growing.
Greenwich Associates interviewed 2,475 institutional investors in the United States, continental Europe, the United Kingdom, Canada, Japan, and Australia, and asked them about their asset allocations and use of investment products, including alternative assets. The findings of this research are summarized in a White Paper, which details trends in institutional use of alternative assets, including hedge funds, private equity, and real estate. The White Paper also presents the conclusions and recommendations of Greenwich Associates’ consultants with regard to risks, due diligence, and strategies for investing in alternative assets.
The results of Greenwich’s 2004 investment management research – including updated allocation levels – will be released in coming weeks.