Investment in alternatives by pension funds in OECD countries has increased from 6 per cent to 19 per cent of total assets under management from 2000 to 2012, according to research by State Street.

The study By the Numbers: The Quest for Performance, discovered a continued appetite for alternatives amongst institutional investors, despite greater concerns about return volatility.

Furthermore, it also found that a globally diversified portfolio including alternatives generated 70 per cent enhanced performance net of fees with marginally higher volatility versus a more traditional portfolio composed of 60 per cent equities and 40 per cent fixed income.

Using empirical analysis, supplemented by manager interviews and survey reviews, the study looked at the investment patterns of institutional investors across an extensive asset profile diversified by geography and a broad use of alternative assets and strategies.

The researchers identified six critical factors driving innovation in meeting the dual challenges of more risk and less returns, including the persistence of low returns, higher return variability, converging correlations, the growing asset-liability gap, a real risk of tail events and illiquidity and the competitive pressure to mimic asset allocation strategies. The performance impacts of investor responses were then traced and distilled into five ways to achieve performance goals including becoming factor-curious, liability-sensitive, liquidity-selling, agency-aware and capacity-building.

“Not all alternatives are created equally, and neither are the investors who turn to them in the hunt for alpha,” said State Street’s Centre for Applied Research global head Kelly McKenna.

“Today’s successful institutional manager will balance a desire for return with an appreciation for the complexity of portfolio risk as well as investment and liquidity constraints while respecting the rapid nature of market events that can implicate return objectives.”

The study was produced by the Center for Applied Research, State Street’s independent think tank, in partnership with the Fletcher School of Law and Diplomacy at Tufts University.

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