Diversification into alternative asset classes remained a popular option for UK pension funds in a disastrous 2008, says Watson Wyatt, with particular attention paid to direct hedge funds and direct private equity. However, real estate has slipped down in the popularity stakes.

The financial consultant's European head of investment consulting, Paul Trickett, said: "Diversification using alternatives is now commonplace, but it comes at a price with large demands on governance budgets and high fees. We have seen progress through better aligned fee structures recently and more pension funds are now either raising their game, by adding to their governance, or simplifying their strategy by moving to lower cost, passive solutions. These developments bode well for a better value proposition in this area."

The number of searches for direct hedge funds conducted by Watson Wyatt in 2008 was 30 per cent higher than in the previous year, and fund of hedge fund mandates fell as a proportion of total hedge fund searches from 44 per cent to 35 per cent. Almost two thirds of searches are now accounted for by mandates to single-manager hedge funds, with long/short equity and multi-strategy being the most popular.

Craig Baker, global head of manager research at Watson Wyatt, added: "Accounting for all the challenges facing the hedge fund industry, we still believe in the ability of highly talented investors to adapt to a changing environment and generate good performance for our clients. While the current crisis will no doubt expose those many hedge funds that are not structured to add value for investors it is an industry that still boasts a high proportion of the world's most talented investors capable of delivering value despite ongoing difficulties."

Baker added that he believes larger pension funds will start to invest in hedge funds directly, rather than through funds of funds, as they gain increasing influence on fees.

Bond mandates increased in 2008 by 25 per cent from 2007, and the majority were UK bonds for liability hedging reasons.

- Pensions Age February 2009

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