While the Pennsylvania State Employees' Retirement System decided to stick a toe in the hedge-fund waters in 1999, CIO Peter Gilbert had been championing the cause for two years prior. There were only a handful of institutions in the large private capital pools, which were controlled by the wealthy at the time, according to BusinessWeek Online

As Gilbert remembers, "We had become disillusioned with traditional money managers' ability to outperform the benchmark over long periods."

This daring move turned out well for the Pennsylvania fund as hedge funds now make up 20% of the plan's assets and have garnered an additional $500 million for the $26 billion state fund.

The Pennsylvania fund has set a trend now being followed by other pension systems. U.S. institutions increased hedge fund assets by 50% in 2004 with an eye to making $300 billion by 2008 according to investment consultants Casey, Quirk & Associates LLC.

A majority of institutions, however, are likening the plunge to a blind leap of faith. Out of 45 top-level institutions polled in May, 59% anticipated a major hedge-fund collapse within two years.

"If the pack is moving into hedge funds, no one wants to be an outlier and risk falling behind," said Chairman David J. Rothkopf of the National Strategic Investment Dialogue, who directed the poll.

Institutions are looking to hedge strategies as their best chance to boost returns and limit risk. This thought process comes as modest stock and bond market returns are expected to continue and money managers are being drawn to hedge funds.

While some institutional investors are looking for the big score, most are not expecting outsized profits.

They're sticking to the "absolute return" and other strategies that shoot for modest returns with less volatility while frequently using funds-of-hedge-funds for diversification.

Another school of thought currently is that the influx of new money is already starting to shave returns. "The party's over," states Joseph Aaron of Wood, Hat & Silver LLC. His investment firm has been withdrawing from hedge funds.

Institutional investors are looking to fund managers with the right skills to make this happen. With the glut of managers, however, it is more probable that institutions will wind up paying inflated hedge-fund fees for paltry returns.


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