Nine out of 10 Asian asset owners are moving to shorten their fixed-income duration in response to the prospect of interest-rate rises as the US Federal Reserve prepares to taper its quantitative easing programme.

Many have been busily shifting out of domestic fixed income to other asset classes including alternatives, according to a report released overnight based on a survey by US consultancy Greenwich Associates.

Domestic fixed-income exposure has been slashed to 23% of overall average assets up to March this year, from 43% in 2008. However, Greenwich notes that these institutions are not rotating out of the asset class entirely – their international bond allocations actually rose to 34%, from 31% in 2012.

Overall, 91% of asset owners surveyed expressed concern over the Fed's QE slowdown plans and say they are shortening duration in response. Greenwich notes that the duration of their fixed-income portfolios averaged 4.2 years to March, from 4.8 years in 2008. The consultancy expects this to shorten to 4.1 years by 2016.

Investors' desire to shift out of domestic fixed income will continue to be gradual – Greenwich Associates' consultant Abhi Shroff estimates that reducing exposure will take a decade for some players, given that half of their portfolios are in local bonds. An increasing 30% of investors are hedging their fixed-income portfolios to protect against a rise in interest rates.

Government agencies have made the most progress in diversifying their portfolios, with 4% in domestic fixed income and 18% in international bonds through March, while Asian endowments have also reduced FI to less than half of assets.

Equity exposure fell to 13% through March 2013, from 16% last year, although Greenwich expects this trend to shift, as 35% of Asian institutions say they plan to increase international equity exposure in the next three years.

Greenwich research indicates that although Asian institutions are increasingly investing with external managers – asset allocations to third-party managers rose by 25% through June from 2012 – the preference is still very much tilted towards managing money in-house.

Asian institutions outsource only $1.5 trillion of assets to external managers, a small percentage of the $9.8 trillion in AUM, and many do not use third-party funds at all.

This is “unsustainably low” given the growth of Asian institutional assets and the need for diversification, Greenwich  argues, noting that overseeing equity, international assets and alternatives strategies internally is a cost hindrance.

Sovereign wealth funds, state pension funds and other large investors with more than $5 billion in AUM employ an average of 22 professionals for internal investment management, compared with 10 for external management.

“Given the cost and human resource management implications of employing an investment professional with the necessary experience and skills, it is unlikely that smaller institutions will be able to afford to maintain the levels of internal staffing required for success,” notes Greenwich consultant Markus Ohlig.

“Most institutions would be better served by gradually increasing the share of outsourced assets as they begin to expand the scope of their investments beyond domestic bonds.”

China Investment Corporation increased allocations to external managers last year to 63.8% from 57% in 2011, although Shanghai consultant Z-Ben Advisors believes this will be short-lived as China’s sovereign wealth fund has said in the past it aims to manage private equity funds in-house with a partner.

Meanwhile, the survey finds that Asian institutions are increasingly turning to alternatives, including hedge funds, private equity and real estate, although allocations remain low compared with global peers.

Over the past 12 months state pension funds and sovereign wealth funds increased exposure to 14%, up from 10% in 2012 and a spike from only 2% in 2008.

Private equity allocations experienced the sharpest rise – institutions excluding Japan bumped up private equity exposure to 6.7% through March from 4.2% in 2012. Hedge fund exposure rose to 3.1% from 2.3%, while real estate increased to 2.7% from 2.6%.

This increase in alternatives is being done by the largest investors in the region, however. Alternatives still remain a small part of most institutions’ portfolios, with Greenwich estimating only one in five regional institutions are in the asset class.

Although smaller institutions have “aspirations” of increasing allocations to hedge funds, private equity firms, and real estate funds, they are often prevented from doing so due to regulations and investment policies.

Greenwich notes that Asian sovereign wealth funds have been forgoing global equity and fixed-income mandates in favour of more specialist strategies focused on emerging market and other regional equities, as well as high yield and corporate credit fixed income, although points out that assessing the managers will prove challenging for Asian institutions at first.

Greenwich researched 199 institutions in more than 15 Asian countries between January and March this year.