PENSION FUNDS should diversify into asset classes that have a low correlation with equities in order to provide pension funds with greater diversification and an "optimal" portfolio allocation, according to pension consultants Hewitt Associates.

In a survey conducted by the firm amongst diversified pension funds from fund managers KBC Asset Management, Irish Life and Eagle Star, it was found that diversification into assets such as commodities and emerging market equities, in addition to more traditional equity and bond funds, resulted in a more "efficient" portfolio or better risk-return profile for investors.

The survey showed that diversified funds are performing better than managed funds in the current climate. On average, the four diversified funds surveyed (Eagle Star Diversified Assets, ILIM Diversified Growth, ILIM Diversified Balanced and the KBCAM Innovator) grew by 0.6 per cent in the second quarter of 2008, compared with a decline of 4 per cent in the Managed Fund Index.

In the year to June, diversified funds fell in value by 9.4 per cent, compared with a decline of 14.8 per cent among managed funds. Most notably, however, in the 12 months to the end of June 2008, diversified funds considerably outperformed their managed counterparts - falling by 12.2 per cent, as opposed to the 20.9 per cent decrease recorded in Hewitt's Managed Fund Index.

Of the four funds, KBC Asset Management's Innovator fund, which invests in areas as diverse as water, alternative energy, commodities and emerging markets, performed the best in the second quarter of 2008, increasing in value by 3.8 per cent, while in the year to June, Eagle Star's Diversified Assets fund performed the best, declining by just 2.4 per cent. In the 12 months to end June 2008, KBC's Innovator fund was again the best, declining by 9.2 per cent.

Indeed, of all the managed funds in the Hewitt index, KBC's Innovator was the third-best performing fund over the past year, behind Irish Life's Secure Performance (+6.2 per cent) and Standard Life's Investment Cautious fund (-9 per cent).

However, as the four diversified funds are recent start-ups, there is no information available for long-term performance.

Traditionally, pension scheme trustees have looked to balanced or managed funds as a means of achieving long-term equity-type returns with lower levels of volatility than equities. In these types of funds, around 70-80 per cent of the portfolio is allocated to equities, and the balance to other asset classes, such as property, bonds and cash.

"This strategy worked very well for Irish pension schemes over most of the last 10 years because a significant part of balanced fund assets were invested in two very high-performing asset classes - Irish equities and Irish property. Volatility was not a concern because generally asset classes were moving in the same direction - upwards. However, the sharp decline over the last 12 months in equity values, particularly Irish equities - and property to a lesser degree - has highlighted the inherent lack of diversification in the typical Irish balanced or consensus fund, and the consequent high level of risk that they carry," says Betty O'Reilly, an investment consultant with Hewitt.

O'Reilly says investment managers are now looking at alternatives, including categories or "themes" such as alternative energy, active currency, emerging markets, commodities, private equity, hedge funds, unconstrained or high-performance equities, together with any number of satellite themes such as water, infrastructure, and forestry.

"A number of these asset classes would in the past have been ruled out by managers on the grounds that they were excessively illiquid, difficult to trade in and legally complicated, as well as requiring considerable in-house expertise and large-size investment commitments. The proliferation of indexed funds and developments in derivative instruments has made such categories more accessible to the broader investment community," she says.

However, O'Reilly warns that the fund manager needs to have demonstrable skill in managing such assets, or in selecting an external manager who can do so. Moreover, she adds that the returns on some of the categories, such as private equity, emerging markets and infrastructure, may take a long time to deliver on expectations, while some asset categories, in particular commodities, may be experiencing a price "bubble" currently, which indicates the need to avoid being over-exposed to such asset classes.

In addition, some of the asset categories are illiquid, which may cause difficulty for managers in optimally rebalancing the funds.