International Equities: Seeking a More Complete Definition

Although U.S. institutional investors have steadily shed their home-country bias and increased their allocations to international equities, most still lack exposure to roughly one-third of the non-U.S. equity market.

A new Northern Trust paper, “International Equities: Seeking a More Complete Definition,” finds investors underweight or ignore three important non-U.S. equity segments. These sub-asset classes — Canada, developed international small-cap stocks and emerging markets — represent $4 trillion of market capitalization, or about one-third of the $12.5 trillion of the total non-U.S. market.

Perhaps the biggest reason for this underexposure is investors’ adherence to the MSCI EAFE Index as the benchmark for international equity allocations. EAFE, the dominant international equity index for more than 30 years, represents about 69% of the non-U.S. equity market cap. Although investors have begun to incorporate allocations based on the MSCI Emerging Markets Index, Canadian equities, at 6% of non-U.S. market cap, and international small-caps, at 9%, remain underrepresented.

The paper’s authors — Steven A. Schoenfeld, chief investment officer, and Stefanie Jaron Hest, investment strategist, both in Northern Trust’s Global Quantitative Management Group — argue the importance of overcoming the “benchmark gap.” Specifically, they say including the overlooked sub-asset classes offers the potential to achieve higher returns while lowering risk through greater diversification. For example, developed small-caps have outperformed EAFE by 6.3% on an annualized basis during the four years ended September 2007. In addition, developed small-caps correlation to the S&P 500 was 0.63 for the three years ended September 2007.

Download a copy of the white paper.

Pension Funds Follow Endowments' Lead

The generally strong performance of U.S. endowments and foundations has caught the attention of their pension fund brethren, according to a study from Greenwich Associates. The firm’s annual report on institutional asset allocation found institutions in general, and pension funds in particular, are getting more aggressive in their asset allocation policies.

In addition, the report notes pension funds also are pursuing strategies to more closely align assets with liabilities.

The average U.S. corporate defined benefit plan decreased domestic equity to 39.9% last year, roughly four percentage points lower than the previous year. That decrease was offset by a similar increase in international equities to 20% in 2007. Among public pension funds, allocations to U.S. equity, fixed income and hedge funds decreased, while assets assigned to international equity, real estate and private equity rose.

For information on how to obtain a copy of the report, go to greenwich.com.

Asset-Liability Matching Increases

Pension plan sponsors worldwide are seeking to lock in funded status by more closely aligning assets and liabilities, according to Watson Wyatt’s “2008 Global Pensions Assets Study.”

The annual study covers both public and corporate pension funds in 11 countries, the largest of which were the United States, Japan, the United Kingdom and Canada. Funds in the study had total assets of US$24.9 trillion at the end of last year, up 8.7% from the previous year.

Liability driven investing is expected to see the biggest increase in usage, but pension plan sponsors also are expected to increase their use of absolute return strategies and alternative investments.

The study also notes an increased interest in separating the alpha and beta components of a portfolio’s total return separately.

On a global basis, pension funds had an average asset mix of 56% equities, 28% bonds, 11% alternatives and 5% cash.

To download a copy of the study, go to watsonwyatt.com.

Public Plans Improve Funded Status

A research paper from the Center for Retirement Research at Boston College finds state and local pension systems generally are as well funded as their corporate counterparts.

The paper, “The Miracle of Funding by State and Local Pension Plans,” states there has been significant improvement in the funding levels of public retirement systems since the late 1970s. Between 2003 and 2006, public sector plans were 88% funded, on average, compared with an average of 86% for corporate plans.

The paper adds that the improvement in funding occurred despite the lack of federal legislation, such as the U.S. Employee Retirement Income Security Act of 1974. The law, which governs private-sector plans, did mandate a study of public retirement plans that highlighted their poor funded status.

To obtain a copy of the research paper, go to crr.bc.edu.

Trustees Face Daunting Investment Challenges

Coping with the ever-changing and increasingly diverse investment environment can be a challenge, even for sophisticated investors. U.K. defined benefit pension trustees listed establishing an appropriate investment strategy as their primary concern, an Aon Consulting survey finds.

Aon asked 250 trustees about the decision-making challenges they face. The survey found 51% of respondents said investments were their top challenge, followed by negotiating employer contributions at 41% of respondents.

The survey also revealed an increasing appetite for alternative investments. More than one-fourth of respondents, 27%, said they expect to shift their portfolios toward alternative assets and away from traditional asset classes during the next five years.

To learn more, go to aon.com.

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