EUROPE - Pension funds are increasingly moving into alternatives but the next growth area could be in the expansion of specialist fixed income mandates and single strategy hedge funds, according to Mercer's review of pension fund asset allocation.

The consulting firm's annual survey of European pension fund asset allocation found equities and bonds still dominate allocations, as the average weighting of pension funds across all 13 countries surveyed was 42% to equities and 48% to bonds, along with 6% in property and 4% in other assets.

However, a closer analysis of pension fund strategies found continental European pension funds are more likely to consider investing in alternatives such as hedge funds to gain diversity, and in light of recent market turbulence executives and trustees may now be more willing to create specialist mandates within key asset classes, in a bid to tap opportunities and limit the potential downside of investing in key sectors.

Fiona Dunsire, UK head of investment consulting at Mercer, noted while 5% of Europe ex-UK schemes have an average 12% allocation to hedge funds compared with 14% of schemes holding a 7% allocation to fund of hedge funds, the situation may shift in the near future as improved knowledge of hedge fund strategies is likely to encourage investment in single strategy hedge funds.

"None of these are going to be a holistic switch. But what we are seeing is more of those traditional mandates being reducedm" said Dunsire.

"There will perhaps be a shift towards more single strategy hedge funds within a portfolio rather than fund of hedge funds or multi-strategy. What we are seeing is an opportunity or particular skillset at an organisation surfaces, and clients asking for that. It means a more focused and specialist market," she added.

Similarly, pension funds are looking to implement fixed income mandates managed by specialist managers, according to Crispin Lace, principal at Mercer, while private equity is again being touted as a potential investment target further down the road.

"In terms of governance spending, [pension funds] are spending more on the bond element than on the equity piece," said Lace.

"Whereas in the past we would spend more time [researching and analysing] the equity portfolio, we are spending a lot more time trying to exploit the anomalies in bonds portfolios and make tactical use of bond opportunities within existing mandates.

"We will see gradual changes in the line-up. If you are looking at using specialists for those opportunities it is not going to happen over night in the mainstream classes but the industry is itself is beginning to recognise the interest. And we are starting to talk about opportunities within private equity, and 2010/11 as being the vintage years," added Lace.

The annual survey itself revealed closed defined benefit schemes are likely to 10% more in bond allocations than open schemes, and will have a maximum of 50% in equities.

Closer analysis of the UK and Irish schemes - with the UK accounting for 70% of the survey results - also suggested both 33% of UK and 47% of Irish schemes will decrease domestic equity holdings, while 20% of UK and 40% of Irish schemes will reduce overseas equities in favour of domestic government bonds, domestic corporate bonds and alternatives (excluding real estate)

It appears there will be a significant shift in Irish risk strategies from 2009 onwards, as the Mercer survey found at least 12% of Irish schemes are looking to increase allocations in private equity fund of funds (FoFs) and 13% will add to commodities, while the number of schemes increase infrastructure, forestry, active currency and global tactical asset allocation (GTAA) holdings will be 10% and 8% each respectively.

Elsewhere, Mercer also found there is now also increased focus on the operational risks to a pension plan, as 70% of those questioned will review their stock lending arrangements in 2009, up from 55% in 2008, and 41% will take a closer look at the back office operations of an investment manager - something pension funds always regarded as "secondary" until the Lehman Brothers collapse, according to Lace.

At least 56% will also review counterparty exposure and cash management while 46% will reconsider their transaction costs - especially as Mercer has found hedge funds are willing to give some pension fund clients discounts for being "stickier" investors - and 38% will look at collateral management.

This year's survey was conducted among 1,000 schemes, split as 69% UK, 10.5% from Germany, 6.9% from Switzerland, 4.3% from Ireland, alongside 3%, 2.6% and 2.1% in France, Netherlands and Spain. The remainder of schemes were based in Norway, Portugal, Sweden and Austria.

Approximately 46% of the schemes surveyed had assets of less than €50m and 9.1% were funds will over €1bn in assets under management, so the survey found "there is often a strong correlation between the size of a scheme, the complexity of its investment arrangements and the quality of its decision-making processes.

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