(April 1, 2011) — Pensions will increase their direct allocations to hedge funds in 2011, a new white paper released by Infovest21 shows.

“Institutionalization, regulation and the challenging asset raising environment are some of the major forces continuing to affect hedge funds and funds of funds in the current environment,” the study notes.

The trends impacting hedge funds / fund-of-funds over the coming year, as outlined in the report, include:

1) Pension underfunding has led to increased interest in hedge funds/funds-of-funds. With pensions worldwide suffering mounting liabilities and hits to their asset values due to 2008, institutions have flocked to hedge funds/funds-of-funds as a potential solution to fill gaps in funding.

The report states: “Hedge funds are increasingly being considered as a surrogate portion of the pension’s entire asset allocation – not just as an alternative asset class. More institutions are becoming comfortable thinking about sources of alpha as opposed to traditional buckets. For example, long/short equity is now becoming part of the equity traditional allocation. So instead of a 5% allocation to alternatives, 20-30% of traditional equity allocations may be placed into long/short.”

2) Large US pensions are increasing direct allocations to hedge funds. “Performance is another reason large US public pension funds are increasingly allocating directly to hedge funds,” Lois Peltz, president of Infovest21, says in the report. “The average hedge fund outperformed funds-of-funds in six of the seven past years. The largest differentials occurred in 2009 and 2010.”

Recent findings by Moody’s Investor Services and Preqin confirm the trend toward hedge funds. A report released by Moody’s last month showed that hedge fund managers will be forced to reduce their fees and risk tolerance while altering their business strategies as pensions increase their allocation to the sector. An earlier report by Preqin revealed that the hedge fund industry is gaining traction. Despite negative returns over a three-year timeframe, public pensions have increased their allocations to hedge funds. Nearly 300 public pension plans worldwide now invest in the asset class, a 51% increase over the past four years. Preqin’s database of institutional investors showed that 295 government pension funds worldwide were invested in hedge funds in the first quarter 2011, compared to 196 plans as of December 31, 2007. Additionally, the research indicated that another 49 public plans are seeking to make their first hedge fund allocation within the next year.

Hedge funds have become more popular among public pensions than private equity, according to Preqin’s report. In total, the amount of public pension assets currently invested in hedge funds is $127.3 billion.

3) Institutions are searching for structural efficiency, obtaining more efficient returns from a fee perspective at both the manager and portfolio construction levels. “To achieve this, some pensions are accessing fund managers at a reduced fee and/or combining replication strategies,” the report by Infovest21 indicates. “Others are combining long-only managers with hedge fund managers as long-only managers are available at lower fees.”

4) Funds-of-funds take a more solutions-based approach, with institutions hiring funds-of-funds for asset allocation studies while others want risk management.

An illustration of pensions moving toward a direct investment approach and away from a fund-of-funds strategy comes from the $48.7 billion Massachusetts Pension Reserves Investment Management (MassPRIM). In February, its Board issued a comprehensive asset allocation review outlining its decision to shift from a fully fund-of-funds investment strategy to incorporating more direct hedge funds.

“Tim Cahill, our previous Treasurer, felt that having a fund-of-funds approach would achieve better diversification,” MassPRIM spokesman Barry Nolan confirmed with aiCIO in February. “But there’s also the argument that with a fund-of-funds strategy, you can reach a point of diversifying too broadly, leading to diminishing returns,” he said, noting the while Cahill, who suffered a tarnished reputation over accusations of political influence, achieved solid returns as Treasurer, concern centered on the middle layer of management that his fund-to-funds approach created.

As of early February, among the nation’s 10 public funds with the largest allocations to hedge funds, MassPRIM and the Pennsylvania State Employees’ Retirement System were the only two funds to remain solely invested in funds-of-funds, according to materials provided by MassPRIM’s board. On the flip side, according to those materials, the hedge fund allocations of five of the top 10 — Pennsylvania Public School Employees’ Retirement System, Virginia Retirement System, the Teacher Retirement System of Texas, the New York State Common Retirement Fund and the Texas County & District Retirement System — were entirely invested directly in hedge funds. Others have a mixed approach. “This brings us more in line with the strategy of the majority of our peers,” MassPRIM’s Nolan said. “We’re not going to do things just because other funds are doing it, but we’re doing it on the belief that performance will be enhanced. We’re putting our toe in the water. We’re not doing a cannonball off a cliff.”