Pension funds that have historically clung to long-only investment strategies are looking to alternatives in an effort to meet expected returns.

Currently, large public pension funds’ average allocation to hedge funds is approximately 8%, in sharp contrast to endowments and foundations, some of which have as much as half of their portfolios allocated to hedge funds.

But each asset class is now competing hard for space in portfolios based on future expected return characteristics.

“With regards to specific sectors, equities continue to die a slow death though since we’ve heard that before, maybe it’s the story of the eternal phoenix reborn from its ashes,” said Philippe Carré, global head of connectivity for trading technology firm SunGard’s capital markets business. “In derivatives, the story is about fixed income and commodities, which have been OTC worlds but increasingly look like becoming listed.”

Over the past five years, pension funds have lowered their return expectations for hedge funds to the 6%-8% range, said Don Steinbrugge, managing partner at Agecroft Partners, a consulting and third party marketing firm which specializes in the alternative investment arena with a focus on hedge funds.

However, return expectations for fixed income over the same time period have declined significantly further.

“Most public pension funds have a large allocation to fixed income managers that manage portfolios against the aggregate bond index, whose expected returns five years go were in the high single digits,” said Steinbrugge. “Since then, we have seen interest rates decline to near historic lows, and credit spreads decline to five-year lows. As a result, forward-looking assumptions for an aggregate bond mandate should be in the 3% range.”

While the asset allocation for most public pension funds “is glacially changing on an annual basis, their actuarial return assumptions rarely change”, Steinbrugge said.

If a pension fund’s performance is below the actuarial return assumption—generally 7% or 8%—then the unfunded liabilities will increase, and the pension fund will require additional contributions.

On average, pension funds were already under-allocated to hedge funds before the significant decline to 3% for fixed income return assumptions. “With current actuarial return assumptions averaging 7.5%, we will see more pension fund assets shift from fixed income to the hedge fund portion of their portfolio,” Steinbrugge said. “This trend will continue as long as interest rates stay low.”

There is also a return towards speeding up the process by which pension funds allocate to hedge funds. The process typically begins will a small initial allocation via hedge fund of funds.

The second stage of the process is investing directly in hedge funds, which may include assistance from a consultant. An overwhelming majority of the hedge funds that a pension plan invests in at this stage are the largest, brand-name hedge funds with long track records.

“Performance is of secondary importance to perceived safety and a reduction of headline risk,” said Steinbrugge.

In the third stage, pension funds shift their focus from name-brand hedge funds to “alpha generators”, which tend to include small and mid-sized funds that are more nimble.

In a study from 1996 through 2009 conducted by software provider PerTrac, small hedge funds outperformed their larger peers in 13 of the 14 years. “It’s much more difficult for a hedge fund to generate alphas with very large assets under management,” said Steinbrugge.

The final stage of the evolution occurs when pension plans stop viewing hedge funds as a separate asset class, and allow hedge fund managers to compete head-to-head with long-only mangers for each part of the portfolio. Many of the leading endowments and foundations have evolved to this point.