The majority of pension schemes want to increase their allocation to hedge funds or start investing in them according to a State Street survey, despite the largest U.S. public fund cutting its allocation.

In September CalPERS, the California public employees pension scheme, said it was going to pull $4bn from its hedge fund investment program. Hedge funds charge comparatively high fees and the majority have underperformed equity markets – the Bloomberg Global Aggregate Hedge Fund index has gained just 2% so far this year.

The State Street survey, Pension Funds DIY: A Hands-on Future for Asset Owners, found that 29% of pension funds that already invest in hedge funds will increase their allocation, while 25% will invest in this asset class for the first time.

The research was based on a global survey of 134 senior executives in the pension fund industry conducted by the Economist Intelligence Unit in August 2014.

Ian Hamilton client management head of asset owners at State Street, told Markets Media: “Hedge funds bring diversification away from mainstream assets and schemes want to invest in the top quartile managers.”

The appetite for hedge funds is part of an overall trend of increasing risk and investing in more alternatives assets in a search for returns. Alternatives have increased from 5% of pension assets in 1995 to almost 20% by 2013 according to State Street.

In the survey 77% of respondents said their institution’s investment risk appetite will rise over the next three years. The majority, 60%, said they will increase allocations to private equity while they will also put more money into direct loans, real estate and infrastructure.

Timo Ritakallio, deputy chief executive chief investment officer at Ilmarinen said in the report that the Finnish pension fund has invested in private equity firms since 1997 and it has been their best performing asset class with an average annual return of almost 12%. “Today, our private equity share is just below 5%, and our target for the end of this decade is 8% of the total portfolio,” Ritakallio added.

Wylie Tollette, chief operating investment officer at CalPERS said in the report that the scheme has adopted a fairly growth-oriented portfolio strategy in order to meet required returns. “If you add up all our equity and growth-oriented assets, our private equity and public equity positions, it comprises almost 62% of the plan’s total assets,” he added. “It’s a relatively high allocation to growth assets for a mature plan.”

Tollette said that CalPERS’ required rate of return is 7.5% despite the low rate environment.

Hamilton said pension funds are discussing whether their return expectations need to be lowered. “We haven’t seen a large sea change in our clients’ discount rates. However trustees and sponsors have never been working more closely and conversations are on the table on reaching mutually agreeable solutions.”

As well as increasing exposure to alternatives, 53% of schemes said they would make greater use of low-cost passive strategies in the next three years in “barbell strategies” which index strategies with higher-risk returns typically provided by alternatives.

Asset management fees have become more carefully scrutinised as it has become more difficult to achieve returns. The report said that Railpen Investments in the UK recently calculated the overall level of fees it was paying fund managers and found it was paying additional charges that were three to four times larger than the £70m upfront fees, and this led to a new insourcing project at the fund.

As a result of the scrutiny on fees, most pension funds, 81%, are planning to manage more of their assets in-house over the next three years in order to cut costs and gain greater oversight into their portfolios.

Mark Fawcett, chief investment officer at the National Employment Savings Trust (Nest), said in the report: “It’s very easy to get the headline figures for the benefits of doing something in-house, but there is quite a lot of risk. You need to put systems in place to minimize the risk of error.”

Roel van de Wiel, asset owner sector solutions, State Street Global Services, said in the report: “Alongside the trend of insourcing the asset management, we see situations where funds still want the complexity of the operations outsourced, rather than recruit specialist staff themselves.”