Institutional investment advisors forecast a continued emphasis on diversification - including into mutual funds - and an increasing interest in non-traditional asset classes for the upcoming year.

"The diversification theme continues to make sense. For those investors that are not as far along in their understanding of some of the newer types of asset classes, such as absolute-return funds and real estate, the evolution will continue and those non-traditional assets will continue to draw interest," Angeles Investment Advisors Principal Michael Rosen said.

Putnam Investments head of Institutional Management John Brown has also seen an increased allocation to alternative assets, but stressed that these types of investments still make up a very small percentage of total pension plans.

"On the margins, there is an increased interest in things like hedge funds, leveraged buy-out funds and real estate, but these still make up less than 10% of total pension plan assets," he said.

Rocaton Investment Advisors Partner Joe Nankof said that investors are likely to continue to look for ways to diversify their portfolios that will better equip them to weather possible downturns in the U.S. market. This could include inflation-linked bonds, emerging-market bonds and equities, and high-yield bonds, he said. Rosen added that diversification is not only about risk-management - it also enhances returns.

"In past years, investors were relying too heavily on equities, and the reason to diversify was primarily risk reduction. Now, the risk for investors is less one of portfolios dropping by 50% and more about watching paint dry," he said.

With equity valuations still relatively high by historical standards, the nominal returns are not very inspiring, Rosen said, and it is hard to reach an investment objective when looking exclusively at stocks and bonds. However, he does not anticipate broad changes in asset allocation anytime soon.

"Overall, I don't see the upcoming year as being radically different from past months. Investors are still absorbing the lessons from the past two years about diversification and rebalancing," Rosen said. Brown agreed, saying the commitment to traditional asset classes is not about to fall by the wayside, and that there is a lot of cash flowing back into equities at the moment.

"What a lot of the big plans are doing right now, and will continue to do for the next six months, is rebalance back to their strategic policy mix, and a lot of these plans are overweight in fixed income, and are looking to get back into equity," he said.

Additionally, underfunded pension plans are getting funding, and the funding is going into equities, Brown said. Overall, he predicts a shift between 2% and 5% toward equities in policy mixes, which he called "significant," if not quite dramatic.

Nankof noted that much of the rebalancing needed to maintain the optimum mix has already been accomplished through the market. "There will be some rebalancing back into equities, but we have seen a pretty nice rally in 2003, which helped a lot of the funds rebalance through market appreciation," he said.

None of the advisors polled expected the recent run on growth companies to have a significant impact on pension fund allocation strategies.

"Up until about six months ago, value had strongly outperformed growth; and prior to that, it was the other way around. One of the lessons we've learned is the importance of a disciplined rebalancing program, meaning that when one is doing really well, we take some off the table and give it to the other," Rosen said.

Copyright 2003 Thomson Media Inc. All Rights Reserved.

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