U.S. institutional investors are shifting money out of fixed income investments into asset classes with the potential to deliver more robust returns, such as hedge funds, according to a new report from consulting firm Greenwich Associates.

Greenwich research reveals that U.S. public and private pension plan sponsors, endowments and foundations reduced their average fixed-income holdings from 26.8% of total portfolio assets in 2003 to 23.7% in 2004.

During that period, U.S. funds kept allocations to domestic stocks roughly stable at approximately 47% of plan assets — a level that is much reduced from the more than 52% reported in 2000 and could fall further if plan sponsors follow through with current plans.

As Greenwich Associates consultant Dev Clifford explains, “Twelve percent of U.S. plan sponsors tell Greenwich Associates that they expect to make significant cuts to their actively managed U.S. equities over the next three years, and another 13% plan cuts in passive domestic equities.”

U.S. funds decreased their expected rates of returns on all major asset classes from 2003 to 2004, says Greenwich. The average annual rate of return expected by U.S. institutional investors from fixed income over the next five years fell sharply from 5.9% in 2002 to 4.9% in 2004. Average domestic equity return expectations among U.S. funds dropped from 8.2% to 8.1% over the same period. The average expected rates of return on private equity fell from 11.3% to 11.1%, Greenwich reports.

Endowments also dropped their five-year annual return expectations for hedge funds from 9.2% in 2003 to just 8.4% in 2004, and public funds lowered their hedge fund expectations from 9.2% to 8.5% and corporate hedge fund expectations fell from 9.1% to 9%.

International equity holdings grew from slightly more than 11% of total fund assets in 2003 to more than 13% in 2004. At the same time, hedge fund allocations grew to 1.6% of plan assets over the past 12 months.

However, despite the reported decrease in expected rates-of-return on hedge funds, the consultants at Greenwich Associates believe that hedge fund investments will remain on its current trajectory of cautious growth, due to the return advantage that the asset class offers over other investment options, and the additional benefits promised by hedge funds.

Institutional allocations to private equity increased from 3% to 3.4% of total assets from 2003 to 2004, and Greenwich Associates research suggests that additional growth could be ahead.

In the next three years U.S. funds are targeting alternative asset classes. More than a third of U.S. institutional investors expect to make a significant increase in their exposure to hedge funds in the next three years, another 30% plan sizable additions to private equity, and almost a quarter plan similar increases to their equity real estate.

Greenwich Associates research suggests that the assets funding these increases will come largely from core asset classes. Between 12% and 13% of U.S. funds expect to make a significant decrease to domestic equities in the next three years, and another 12% plan to cut allocations to passive international stocks. In addition, one-in-10 U.S. funds plan to make meaningful cuts to their fixed-income allocations in the same period.