Institutional investors favoring indexed equities

GREENWICH, Conn. — Institutional investors inched back into domestic stocks last year, focusing particularly on indexing, while cutting fixed-income allocations, according to a new report on asset allocation strategies from consultant Greenwich Associates.

The report is based on interviews with executives of more than 1,000 of the largest corporate and public pension funds, endowments and foundations, with assets totaling $5.3 trillion. The interviews were conducted last September and October.

The survey also showed how little asset allocations changed in 2003, in large part because nearly 80% of respondents rebalanced back to their target allocations, Rodger Smith, managing director at Greenwich, said in an interview.

"Over the next three years, around 30% said they plan to make significant changes in asset allocation, mainly by increasing their allocations to international equities and alternatives, including real estate equity, private equity and hedge funds," Mr. Smith said.

In 2003, these investors refocused their asset allocations slightly from the days of the bull market.

"But the modest reallocations away from domestic equity to fixed income after the market slumped in 2000 appear to have run their course," Greenwich consultant Chris McNickle said in the report.

"The main difference between current allocations and those of the earlier bull market is that now these funds are concentrating on approaches that might add a little zing to the returns," Mr. McNickle noted. Within domestic equity portfolios, enhanced indexing increased the most, jumping to 9.9% of domestic equity portfolios from 5.9% the previous year.

Total domestic equity holdings, which two years ago slipped below 50% for the first time since 1996, remained almost steady at 46.9% of total assets in 2003 (vs. 46.6% in 2002). At the same time, passively managed stocks climbed to 18.9% of domestic equity portfolios from 17.5%. And fixed-income allocations, which surged after the 2000 market downturn, dropped about a percentage point in 2003 to 26.8% from 27.7%.

Hedge funds continued to attract the attention of institutional investors of all types, but Greenwich research suggested that the asset class' rate of growth could slow in coming months. That's because of a recovering stock market, an inability to supply enough capacity to meet the needs of the largest corporate and public funds, and concerns about transparency, risks and fees.

In fact, officials at endowments and foundations surveyed by Greenwich said they expected to cut their current 14.9% allocation to 14.2%. Endowments and foundations are the largest institutional investors in hedge funds, with an estimated $47 billion in commitments, compared with $15 billion in commitments from corporate funds and $5 billion from public funds in the survey. Funds of funds were the favored category of hedge fund investment by corporate and public pension funds because of their diversity and relatively limited risk profiles.

Public and corporate pension fund officials said they expected to increase hedge fund investments in the next three years. To date, however, their progress has been slow, the report found. Public funds allocated just 0.2% of total assets to hedge funds in 2003, up from 0.1% in 2002, while corporate funds increased their hedge fund holdings to 1.3% of assets in 2003 from 0.8% in 2002.

Meanwhile, the number of funds rebalancing increased by 10 percentage points to 79% in 2003, and large funds rebalanced more aggressively than their smaller counterparts.

Close to one-third of fund executives surveyed plan some major shifts over the next three years. Some 29% plan to add to hedge funds; 23% expect to add private equity; 19% plan to expand equity real estate; 9% predict they'll decrease fixed income; and about 6% plan to increase active equity investing.

Also over the next three years, 18% of companies expect to reduce their allocations to their own securities. Currently 13% of companies invest in their companies' own securities, up from 11% in 2002. The allocation among those funds is 7.3% of total assets, up from 6.6% in 2002. The increase was probably driven by corporations' need to fill funding gaps using company securities rather than cash contributions, according to the report.

Funding gaps are likely to remain a problem for corporate funds, based on their rate of return expectations. They reduced their rate of return expectations to 8.5% in 2003 from 8.9% in 2002, but the revised number is still high and leaves them short of the goal, said. Mr. Smith said.