LONDON (Reuters) - Pension funds may be attracted back into rising equity markets by new techniques for investing in an asset class they shunned for years as volatile and costly.
Boosting equities and "alternative" investments such as real estate, private equity and hedge funds may seem obvious for pension funds needing to boost pallid returns from bond-heavy portfolios suffering negligible or even negative real yields.
However, high equity volatility since 2000 has been a big turn-off for the $35 trillion global pension fund industry, not least because huge waves of retirement in many aging western countries are due over the next decade.
They have also been shy of the high transaction fees associated with investing in equities due to the frequent buying and selling of different stocks to beat investments benchmarks.
Frustrated by little or no extra gains from costly active investing, many are now looking at more passive, cheaper and simpler strategies.
Often called "Smart Beta", one approach aims to follow certain benchmark indices passively but allow investors to tilt weightings themselves based on their preferences such as volatility or momentum, allowing them outperform the main index.
Smart beta is half way between active and passive investing. For example, an investor can take the S&P 500 index .SPX but overweight stocks with lower volatility to create a new smart index. Investing in this has potential to outperform the original benchmark index and is cheaper than paying an active manager to trade S&P stocks.
At least $20 billion of pension fund assets tracked by consultancy Towers Watson is already invested in smart beta strategies. Early adopters include Danish fund PKA, the Dutch PNO Media fund and Britain's Wiltshire County Council fund.
Consultancy bfinance found 43 percent of respondents in its survey of pension funds representing $350 billion say they are considering moving traditional passive investments to smart beta.
"There's general dissatisfaction with some active strategies. They're expensive and some have proven in this choppy market very volatile. People typically want lower volatility to minimise capital loss," said Olivier Cassin, managing director at bfinance.
"They also want to do it in a cheaper manner than via an active strategy. There's a willingness to reduce overall fees ... When portfolios are in negative territory, fees are becoming even more important. It changes the way equity portfolios are invested."
There certainly is a growing move away from active equity investment. CalPERS, the biggest U.S. pension fund, is considering a move to switch all of its portfolio to passive, according to specialist paper Pensions & Investments.
Managing over $250 billion of assets, CalPERS - the California Public Employees' Retirement System - already has half of its portfolio invested in passive strategies.
Data from Thomson Reuters Lipper shows passively managed equity funds have attracted $1 trillion of inflows since 2003, while $287 billion flowed out of active ones.
Smart beta often uses exchange-traded funds, making it easier for pension funds to buy and sell in a way hedge funds do. Nomura estimates assets of ETFs associated with smart beta have grown to $160 billion, up 166 percent since 2008.
"(Smart beta) is empowering people to cut the middleman. You can create your own hedge funds. It's allowing people achieve their own salvation with their own toolkit," said Tony Morris, Nomura's global head of quantitative strategies in fixed income.
And pension funds are beginning to benefit from gains in world stocks .MIWD00000PUS, which hit almost five-year highs last month and with developed market bourses alone up 10 percent in 2013 to date.
The aggregate deficit in pension plans sponsored by S&P 1500 companies fell 34 percent in the first quarter to $372 billion in March from a record level at end-2012, according to Mercer.
Further gains in the equity market could convince more pension funds to allocate their assets back to equities.
"If great migration (away from bonds) happens, it will be very costly for all governments. And if investors jump on the bandwagon, there might be a self-fulfilling momentum," Timo Loyttyniemi, managing director of Finnish state pension fund VER, told Reuters.
"But after a transition period it may also be a welcomed event. Currently pension funds are earning low yields on government bonds. That is not in balance. Negative real rates are a real risk for pension funds in the long term."
Editing by Ruth Pitchford