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UK pension funds keep faith in alternatives, says Watson Wyatt

UK pension funds advised by investment consultant Watson Wyatt continued to diversify into alternative asset classes in 2008, particularly into direct hedge funds and direct private equ

UK pension funds advised by investment consultant Watson Wyatt continued to diversify into alternative asset classes in 2008, particularly into direct hedge funds and direct private equity, but significantly less into real estate.

‘Diversification using alternatives is now commonplace, but it comes at a price with large demands on governance budgets and high fees,’ says Paul Trickett, European head of investment consulting at Watson Wyatt (pictured).

‘We have seen progress through better aligned fee structures recently and more pension funds are now either raising their game, by adding to their governance, or simplifying their strategy by moving to lower cost, passive solutions. These developments bode well for a better value proposition in this area.’

In 2008, Watson Wyatt conducted 30 per cent more searches for direct hedge funds compared with the previous year, while fund of hedge fund mandates fell as a proportion of total hedge fund searches from 44 per cent to 35 per cent.

Mandates to single-manager hedge funds now account for around two thirds of searches, with long/short equity and multi-strategy being the most popular.

Craig Baker, global head of manager research at Watson Wyatt, says: ‘Accounting for all the challenges facing the hedge fund industry, we still believe in the ability of highly talented investors to adapt to a changing environment and generate good performance for our clients.

‘While the current crisis will no doubt expose those many hedge funds that are not structured to add value for investors, it is an industry that still boasts a high proportion of the world’s most talented investors capable of delivering value despite ongoing difficulties. We believe that the larger pension funds will start to invest in hedge funds directly rather than through funds of funds as they target particular types of hedge fund and start to have more influence on fees.’

Last year UK pension funds awarded around one quarter of the number of real estate mandates than the previous year, taking searches back to levels last seen in 2003. There was a continuation in the shift away from pure UK real estate mandates to those including overseas allocations.

Baker says: ‘While real estate has evolved considerably in a relatively short period of time, 2008 did not represent good timing for allocations to this area.’

Private equity investing continues to attract substantial interest from UK pension funds and the number of new mandates awarded increased by more than 40 per cent in 2008 compared with 2007. This was mainly due to larger funds implementing their diversification strategies directly rather than via funds of funds, which increased the number of selections.

As a result, there were more direct allocations than fund of funds allocations in 2008, confirming a trend which started two years ago. Allocations tended to focus on mid-market buyouts and distressed strategies. In addition, the firm awarded ten new infrastructure mandates compared with none three years ago.

‘The era of cheap and readily available debt combined with rising prices is over and the new world will reward those long-term and selective managers with strong track records of creating value through accelerating the earnings growth of their portfolio companies,’ says Baker. ‘As such these managers will provide a significant range of investment opportunities to achieve good investment returns, either directly for higher governance pension funds or via funds of funds for other pension funds.’

In 2008, the number of bond mandates awarded increased by 25 per cent from the previous year, with the majority being UK bonds, for liability hedging reasons.

While still the dominant asset class, the number of equity mandates fell slightly in 2008. Global equity mandates accounted for the majority of these and include a significant number of long-term long-only equity mandates.

Manager selection activity globally at Watson Wyatt increased by around 15 per cent in 2008 to over 700 selections, reflecting USD65bn of assets moved.

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