JapanÆs big institutional investors raised their exposure to hedge funds in 2006 and are likely to do so again in 2007, but performance is becoming a worry, according to a survey by Nomura Research Institute.

The survey was commissioned by the Tokyo chapter of the Alternative Investment Management Association, says Sadayuki Horie, senior researcher at NRI and chairman of Aima JapanÆs research subcommittee. He presented the findings at an Aima conference last week.

NRI surveyed 18 institutions, including six commercial banks, five life insurers, two casualty insurers, three trading firms and two other institutions.

Last year saw a remarkable increase in hedge-fund exposure: whereas in 2005 a similar survey found a quarter of investors had allocated over Y100 billion to hedge funds, now half of the respondents do. And now every respondent says it has at least some allocation to hedge funds.

Most companies increased their hedge-fund investment by 5% or more in 2006, and the majority say theyÆll do the same in 2007. The exception was among regional banks, which fled hedge funds last year in anticipation that local interpretations of Basel 2 banking accords would require prohibitive reserves. But other large financial institutions more than compensated.

Similarly, more institutions were dedicating teams to investing in hedge funds, with two-thirds reporting they have four or more staff in that role.

What hasnÆt changed is expectations. Institutions in Japan say they are increasing exposure to hedge funds for absolute returns, and to a lesser extent for diversification. About a third of investors expect return targets of 5-7%, with a handful demanding 10% returns and others settling for the 3-5% range. And strategy types havenÆt changed either, with most assets going to equity long/short, and large allocations also to event driven, multi-strategy and fixed-income arbitrage.

Funds of hedge funds continue to be the main access route, with only two or three respondents investing solely in single-strategy funds û but now only a fifth of institutions rely strictly on funds of funds.

So the great majority use both, and most investors will rely on six or more ægatekeepersÆ at any time. In terms of capital structure, more than half of institutions access alternatives through special accounts, rather than in co-mingled vehicles. And most investors say they are willing to sacrifice liquidity (accepting quarterly rather than monthly lock-ups) if it can deliver higher returns.

When it comes to risk, most investors using funds of hedge funds focus on the gatekeeperÆs risk-management skills, and to a lesser degree their skill at picking good underlying managers. But investors are relatively sanguine about operational risk factors.

For investors tapping individual hedge funds, their biggest concern now is investment performance, says NRI. Institutions are now focused on monitoring the investment strategy. Investors are not very interested in the broader issues of risk budgeting or stress testing; presumably they are confident about investing in hedge funds as an asset class, but realise they need to manage this exposure wisely.

Horie says that all financial institutions are concerned with the issue of declining returns. ôThe proportion of respondents that answered ævery interestedÆ has increased dramatically,ö he says. He believes that large financial institutions such as life insurance companies and mega banks conduct good due diligence, but that regional banks and pension funds need to catch up.