Dabbling in Alternatives May Be Fruitless

According to the Greenwich Associates research,   institutional investors who try to get by with small alternative allocations to private equity, hedge funds, and real estate may well be shouldering new costs and be forced to deal with a new complexity with little chance of meaningful returns.

 “Dabbling in alternatives demands a disproportionate amount of resources for monitoring and managing,” said 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 midsize funds may need outside help and will benefit from fund-of-funds structures.”

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, according to the research. Even with this expansion, however, Greenwich Associates said many funds are still at allocations far below levels at which they will have a bearing on overall returns. At the moment, 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% in 2001.

“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,” Greenwich Associates consultant Chris McNickle asserted. “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, four in 10 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. British and Canadian usage is shy of that level, with approximately one in seven pension funds using the instruments, while private equity is almost non-existent in Japan.

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 represented just $50 billion, although that was a significant jump from the $32 billion invested the year before. As with private equity, European hedge fund allocations 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. US 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.