Alternatives, non-U.S. equity to stay in demand

Demand for managers of hedge funds and other alternatives, along with non-U.S. equity, is expected to be high for the remainder of the year, experts say.

"There was very strong search activity for hedge funds from pension funds and endowments in the first half of the year, and we expect there will continue to be a lot of interest in the second half," said Barry Colvin, president and chief executive officer of Tremont Advisors, Rye, N.Y., a hedge-fund-of-funds manager.

"We expect to see more non-U.S. equity searches and more alternative investment searches in the second half of the year," said Yariv Itah, manager of research for Casey Quirk & Acito LLC, Darien, Conn.

Statistics from Mercer Investment Consulting's Tracker Database show assets committed to hedge funds during the first half of 2004 were more than double that of a year earlier, said Bob Stein, a consultant at Mercer in Louisville, Ky. There were 31 hedge fund hirings, totaling $2.5 billion, in the first half of 2004, up from 21 totaling $1.2 billion a year earlier.

On the international equity side, "we think the long-term trend … will see mandates carved up into style categories such as international value, growth and small cap, and away from international core mandates," Mr. Itah said. He also anticipates a "short-term tactical trend away from fixed-income investments because of rising interest rates."

According to a quarterly review from Casey Quirk & Acito, global equity, emerging markets equity and small-cap international equity had their strongest-ever quarterly net inflows in the first quarter — $8.6 billion, $4.7 billion and $2.1 billion, respectively. The second-quarter review won't be available until next month.

And Mercer's Tracker shows 34% of the international equity hires that listed an investment style in the first half of 2004 were emerging market and small-cap equity, representing 18% of the money placed in international equities.

There's some disagreement as to how the trend is likely to play out in the second half of the year.

Kelly Cliff, manager of global manager research at Callan Associates Inc., San Francisco, said he expects more search and hire activity in non-traditional asset classes such as international small-cap equities and high-yield bonds.

Investments that are less sensitive "to the overall equity and bond markets, for which the forecast returns are still low, should do better," Mr. Cliff said. "People will be looking into subsets of those markets."

He predicts "concentrated, highly specialized asset classes" will do well. "Before, there wasn't the need to be so proactive, to go into less traditional asset classes when the broad markets would provide good returns," Mr. Cliff said.

He also thinks global balanced mandates that use global tactical asset allocation might increase. "If you hire a global balanced manager they could rotate, say, into international stocks for a short time period and then rotate back to domestic equities," said Mr. Cliff. "To get better returns, plan sponsors would give investment managers broader mandates and discretion to go into other asset classes if they see them doing better."

Casey, Quirk's Mr. Itah said the level of search activity in the second half of 2004 might not keep up with the first half, although the amount of money flowing into non-U.S. equities and alternative investments could still be significant.

Don Bartolai, a consultant with Mellon Human Resources & Investment Solutions in Chicago, said the consultants at Mellon expect a sharp decline in search and hire activity in the second half of 2004.

"Most people who are thinking about making changes did it in the first half of the year," he said. According to Mellon consultants, pension executives use the second half of the year to get the new managers in place.

Mr. Bartolai said an increase in searches and hires to replace the mutual fund companies that had "fiduciary issues" as a result of the mutual fund trading scandal, combined with performance problems, was the big trend for the first six months of the year.

Janine Baldridge, director of U.S. consulting at Russell Investment Group, Tacoma, Wash., agreed, but added, "While there was a lot more scrutiny (of managers), we did not see an across-the-board termination of managers."

Mr. Bartolai also said that during the first half, institutional investors replaced small-cap and midcap domestic core equity and value equity funds that "stuck to their styles and missed the run-up in growth stocks in 2003."

Tremont Advisors' Mr. Colvin noted that search and hire activity in the hedge fund market seems to be connected to how the equity markets did in the previous quarter. If the equity markets were down, hedge fund search and hire activity tends to go up. "If the equity markets are strong in the second half of the year, I expect hedge fund (searches and hires) to slow from the explosive growth they had in the first half of the year."

Frank Russell's Ms. Baldridge said "less traditional investments" — such as hedge funds, commodities and Treasury inflation-protected securities — were the most popular with the firm's pension fund clients.

"There's a growing interest in using a wider variety of investment strategies," said Ms. Baldridge. "People are trying to understand the risk and return of all these different strategies."