Institutional investors show a continued appetite for alternative investments despite heightened concerns about return volatility, according to a new study Center for Applied Research (CAR), State Street’s independent think tank.

The study, ‘By the Numbers: The Quest for Performance’, was produced in partnership with the Fletcher School of Law and Diplomacy at Tufts University (Fletcher).

Using empirical analysis, supplemented by manager interviews and survey reviews, the study looks at the investment patterns of institutional investors across an extensive asset profile diversified by geography and a broad use of alternative assets and strategies.

CAR and Fletcher identified six critical factors driving innovation in meeting the dual challenges of more risk and less returns, including the persistence of low returns, higher return variability, converging correlations, the growing asset-liability gap, a real risk of tail events and illiquidity and the competitive pressure to mimic asset allocation strategies.

The performance impacts of investor responses were then traced and distilled into five ways to achieve performance goals including becoming factor-curious, liability-sensitive, liquidity-selling, agency-aware and capacity-building.

Suzanne Duncan, global head of research at State Street’s Center for Applied Research, said: "The search for performance remains elusive. As institutional investors’ creativity and patience continue to be tried, meeting performance challenges demands a disciplined core, innovative thinking and flexibility."

Other findings of the research include:

The move to alternatives can significantly enhance performance

  • A globally diversified portfolio including alternatives generated 70% enhanced performance net of fees with marginally higher volatility versus a more traditional portfolio composed of 60% equities 40% fixed incomei
  • Among Organization for Economic Co-operation and Development (OECD) pension funds, the move to alternatives has been significant, rising from 6% to 19% of total assets under management from 2000 through 2012

The performance gap is widening

  • The differential between the best and worst performing private equity managers has increased more than 38% from 13% pre-crisis to 18% post-crisis

Kelly McKenna, global head of State Street’s Center for Applied Research, said: "Not all alternatives are created equally, and neither are the investors who turn to them in the hunt for alpha. Today’s successful institutional manager will balance a desire for return with an appreciation for the complexity of portfolio risk as well as investment and liquidity constraints while respecting the rapid nature of market events that can implicate return objectives."