Less liquid strategies and asset-classes are poised to be the main beneficiaries of a continued shift in global institutional investor allocations. Having warmed to equities following our spring 2009 survey, the second in this series, pension funds started to move down the liquidity scale, investing into riskier assets and diversifying into alternatives. This trend was confirmed in our third and last asset allocation survey in the winter of 2009. Our new poll, conducted during the flash crash of May 2010, provides further confirmation that investors are carrying through with this diversification process. The leading beneficiary of this trend is infrastructure. Overall, the three-year outlook for commodities, private equity, portable alpha and absolute return strategies is also positive. Together with infrastructure, they seem to be the beneficiaries of a change in investor preferences away from equity. Viewed on their own many of these less liquid strategies carry more risk. Combined together, they provide a sought-after diversifier.

We asked investors to provide both their six-month and three-year target asset allocation outlooks. The difference between the increase and decrease in asset allocation changes in the coming six months versus three years shows infrastructure as the most attractive asset class in the alternative segment. Asked how they expect their target asset allocation to change in the coming three years, 38% of respondents say they will increase their target asset allocation to infrastructure while 6% plan to decrease. Twenty-eight percent of respondents plan no change while the rest have no exposure. “As interest-rates have moved lower, we have to diversify into new areas such as infrastructure to achieve the kind of returns ultimately needed to pay out pensions,” notes Staffan Sevón, CIO of Veritas Pension Insurance.

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Among core assets, the three-year outlook for fixed-income is the brightest. The chart below shows the difference between the increase and decrease in fixed-income allocation changes in the coming six months versus three years. The findings reflect that an increase in interest-rates does not seem to be of strategic concern to investors with a long-term outlook. These pension funds need bonds in their portfolios for liability-matching and to meet the ageing demographic profile of their pensioners. They also need bonds to avail themselves of the stricter reserve requirements for equity under Solvency II, which is set for adoption in 2012. On the whole, their preferences have shifted in favour of higher-quality bonds. “The investments will probably be mainly in high-grade corporate and sovereign debt,” notes Matt Fuller, Pensions Investment Manager at Kingfisher plc. In the core, segment, caution is a strong theme at the moment. “We will increase the safe and cash generating part of the portfolio because that gives more protection and cashflow to make new investments in times of market turmoil,” notes Ole Njarheim at IKM Norway. “The investment quality of the fixed-income portfolio will depend upon where we are in the cycle. At the moment, it is mostly investment grade.” 

When we consider their six-month outlook, investors may be more likely to be impacted by headline concerns stemming from the Greek deficit crisis and the widening of sovereign bond spreads across the PIIGS. Given the difficult environment in the lower-quality sovereign bond segment, investors’ six-month tactical views reflect a more moderate appetite for bonds (though it is far from negative). Indeed, most of the respondents do not anticipate any change in their bond target asset allocation in the next six-months while 13% anticipate an increase and 11% a decrease. When we look three years out, the outlook for bonds improves visibly: Forty-four percent anticipate an increase, 22% a decrease and 34% plan no change. “We expect Solvency II regulations will support a higher allocation to bonds,” notes Kjetil Houg, CFO and CIO of the Oslo Pensjonsforsikring AS. Time and again, pension funds cite Solvency II and the demographic profile of the scheme as reasons for planning to increase their bond allocation. “We want to reduce expenses and funding volatility on a FAS 97 basis and prepare for Solvency,” notes Thak Bhola, Pension Fund Administration Manager at Goodyear Canada. “Our pension plans are very mature with members retired or nearing retirement. Our actuaries advised against equity risk.”

We identified this negative sentiment toward equity in our winter 2009 survey, in particular over a three-year time horizon. This trend is still very much supported by our current results. They show investors are still concerned about the strength of the global recovery, with growth forecasts in Europe being cut as recently as May. Once again, when we look at the difference between the expected increase and decrease in equity allocation changes in the coming six months and three years, we see net outflows out of equity. In terms of expected commitments, it ranks at the bottom of all asset classes.

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Our results indicate that unbiased and thorough due diligence are back on the agenda, given the emergence of more complex strategies, alternative products and increasingly crowded manager universe, not to mention the scale of fraud within the hedge fund industry. This last point is a topic we take up in a report on UCITS III which some hedge funds are turning to in order to provide above market returns with less leverage within a more regulated regime. Whether they achieve their historic above returns within such a regime is still an outstanding question and one, which our survey suggests, is not something most pension funds seem to be entirely sold on. In fact, target allocations to FoHFs are only second worst to equity. On the issue of manager changes, fewer cite underperformance and review of strategic asset allocation as the main reasons for changes in this survey. (See the chart below). It asks why pension funds changed their manager(s) in the past six months. The leading reasons are the same, though more pension funds are, on the whole, satisfied compared to our previous results.

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Research for the survey, which is the fourth in our asset allocation series, was conducted in May 2010. Our questions were sent to a wide cross-section of pension funds, almost half (46%) of which are corporate followed by public pension funds (30%) and endowments (8%). They have a total AUM of €92bn. Thirty-three percent, the largest segment, manage between €2-5bn in AUM while 8% have more than €5bn in AUM. The pension funds have, on average, a 44% target allocation to equity, 37% to bonds, 16% to alternatives and 3% to cash. The charts below show a more detailed profile of the participant universe.

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