GREENWICH, Conn. -- Too much of a good thing leads to greater diversification; or at least that is how pension funds and endowments are responding to 1998's investment performance.
Tax-exempt institutions earned returns of close to 20% in 1998, largely on the strength of the stocks of the largest U.S. companies. But these gains were earned during uncertain times, leading these institutions to spread their risks around, putting more money in foreign equities, domestic small-capitalization stocks, hedge funds and private equity partnerships, according to the 1999 Greenwich Report "How Funds are Coping with Uncertain Markets."
Published by Greenwich Associates of Greenwich, Conn., the report is based on interviews with nearly 1,500 fund professionals in the United States. Institutions with total assets ranging from $100 million to more than $5 billion were interviewed.
The report also notes that pension funds and endowments are continuing the trend of indexing U.S. equities.
Suggest dropping core
The Greenwich Associates consultants recommend that institutional investors index their core portfolios; develop the proper long-term portfolio mixes and investment policies; and rely more on their investment managers for input.
The most important element of the study was tax-exempt institutional investors' continued belief in the benefit of asset allocation, according to Roger Smith, a partner with Greenwich Associates.
"Our research clearly shows their appreciation of the fact that asset allocation is the key to long-term success in fund management," Mr. Smith said. "It demonstrates that plan sponsors are continuing to diversify in the face of some potentially discouraging recent developments, and that they are initiating incremental diversification, which promises additional protection or returns."
Foreign stocks were the greatest beneficiary of the diversification trend, even though most foreign markets underperformed the United States.
"The surprising aspect of this is that they (tax-exempt institutions) are planning these increases even though they are expecting their foreign investments to continue to underperform domestic stocks," said Linda Nockler, an associate with Greenwich Associates.
Underpeformance by foreign stock markets actually caused a small reduction in the proportion of U.S. assets invested abroad in 1998, which fell to 11.8% of total assets from 12.3%. Plan sponsors, however, expect foreign asset allocations to increase to 12.9% by 2001, the report states.
The number of plan sponsors using small-cap stocks is up substantially, Mr. Smith said. According to the Greenwich research, 71% of the funds surveyed had small-cap portfolios in 1998; 67% had them last year; and 62% in 1996.
The Greenwich consultants said they were most surprised by the increased interest in hedge funds, particularly by larger pension funds.
"Overall, fund usage is steady at 9%, but the proportion of plan sponsors that would consider using hedge funds has jumped from 7% in 1997 to 13% in 1998," Ms. Nockler said.
"At the largest corporate funds -- those with over $5 billion -- usage is around 15%, and 'would consider' is at 23%," said Charley Ellis, managing partner.
The amounts that pension funds are placing in hedge funds vary widely, said Bjorn Forfang, vice president.
"The amounts they tell us are anywhere from $3.4 million to $200 million, and the percentages all the way from 2.4% to 22%," Mr. Forfang said. "One fund says very specifically that it has $20 million, or 13% of its assets, in hedge investments."
More private equity
Private equity and international real estate also realized gains in assets under management, according to the report.
Domestic equity indexing continues to gain prominence as an investment strategy, particularly among large public pension funds, the report states.
Greenwich Associates' research indicates that passive domestic equity now comprises 18.3% of total assets among all institutions, up from 13.3% in 1995.
The trend to passive is particularly strong at the largest public pension funds. Those with assets greater than $5 billion have an average of 30% of their domestic equity money managed passively, compared with 20% in active management.
"The very large public funds expect the amount they index to be (almost) double that managed actively," said Lea Hansen, a principal with the firm. "Our research indicates that in 2001, the proportion will be 31% passive and 16% active."
The major reasons for this trend are the increased number of professional money managers, money management costs and the growing number of defined contribution plans, the report states.
The greater number of professional money managers makes it more difficult for an individual to beat the market; indexing costs five basis points vs. 50 basis points for active management; and corporate defined contribution assets --which are growing faster than defined benefit assets -- are being invested passively.