Large, diversified hedge funds with institutional-quality operations are more likely to survive their smaller rivals as the sector continues to contract, according to a research note by Morgan Stanley.

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Institutional investors should ‘slowly and carefully’ invest cash reserves in emerging market and high-quality US blue chip equities, says Jeremy Grantham co-founder of GMO, who expects imputed 7-year returns for the sectors to moderately outperform and be substantially better than their averages in the last 15 years.

However, declines to new equity market lows should be expected in the next two years, since market corrections historically overshoot on the downside after major asset bubbles have burst, Grantham writes in his most recent quarterly letter.

The ever-bearish investor predicts that the S&P500 would probably fall to 600 or lower in the next two years, surpassing 750, which was reached in November 2008.

For long-term performance, investors should build portfolios that are more resistant to inflation and less sensitive to potential weakness in the dollar, Grantham writes.

“These are two serious problems that we may have to face as a consequence of flooding the global financial system with government bailouts and government debt.”

But Grantham’s commentary extended beyond government fiscal policy to criticise members of the finance team chosen by US President Barack Obama.

“These are momentous days in which government actions may well have make-or-break impact, but my confidence in government and leadership is at a low ebb.”

The self-proclaimed “contrarian and a nitpicker” tagged Obama’s Treasury nominees as the “Teflon men”, because they failed to question the policies set by Alan Greenspan, the former chairman of the Federal Reserve, or combat the formation of the US housing bubbles. Â

They drew criticism for their apparent links with Robert Rubin, the former US Treasury Secretary and special adviser to Citi as it amassed billions in treacherous mortgage-backed securities. According to Grantham, Rubin “helped to create an environment where prudence was a career risk and CEOs felt obliged to keep dancing”.

Members of the Obama finance team were scathingly labelled “Rubinesque retreads”.

Grantham took aim at newly sworn-in US Treasury Secretary, Tim Geithner, for not questioning Greenspan’s policies during his time as a member of the Federal Open Market Committee.

It was this perceived lack of dissent that concerned Grantham most.

“Our financial ship is not doing a passable imitation of sinking because of a lack of intelligence. What was lacking was the backbone to publicly resist the establishment’s greedy joyride of risk-taking and sloppy standards.

“There was plenty of intelligence, just not too much wisdom. So it would be very encouraging if there were someone included in Obama’s administration who had actually blown the whistle…If only there was someone with real toughness who could do unpopular things.”

The appointment of Paul Volcker, who as Fed chairman helped tame US inflation in the 1980s, to lead Obama’s Economic Recovery Advisory Committee, is an exception. But Grantham lamented the notion that Volcker, with his “preference for high standards of financial integrity and the backbone to push through unpopular but necessary actions,” would likely “resign in a year if they don’t get serious”.

However, Obama’s stress on strong, rapid government spending to combat the financial crisis has countered the “animal spirits” – or widespread negative sentiment – affecting US economy.

“At times like this, animal spirits need nurturing. Obama’s election will help, at least for a while; talking up the power of stimulus will help, and avuncular, optimistic advice from influential figures will not go amiss.”

While liability-driven investing (LDI) has been gaining in popularity for several years among mainly defined benefit pension plans, the strategy and products are about to get an upgrade in sophistication, according to Russell Investments.

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The Organisation for Economic Co-operation and Development (OECD) has called for policy changes after pension funds around the world lost one fifth of their assets – equivalent to $US 3.3 trillion – in 2008.

By October, pension assets of funds in OECD countries had plunged by nearly 20 per cent (22 per cent in real terms) relative to December 2007. Including other private pension assets, such as those held in Individual Retirement Accounts in the US and similar personal pension plans in other countries, the losses increased to about $US5 trillion.

“Most of the loss is accounted for by pension funds in the United States ($US2.2 trillion out of the total OECD loss of $US3.3 trillion) as they account for more than half of all OECD countries” pension fund assets and had the second worst investment performance,” the OECD noted in its latest issue of Pension Markets in Focus.

Irish pension funds, which performed the worst, were the most exposed to equities (see “No luck for Irish funds”, Top1000Funds.com), followed by the US, the UK and Australia. In absolute terms, the UK posted the second largest loss ($US0.3 trillion), followed by Australia ($0.2 trillion).

The OECD said that even before the crisis there had been warnings about the need to reform private pensions.

The organisation is now calling for greater expertise and knowledge on pension fund boards and the appointment of independent experts. Good governance has particularly been a problem for smaller funds, making a strong case for consolidation of the industry in some countries, it said.

The defined benefit (DB) pension plan policies have actually exacerbated the downward spiral in assets in many countries, the OECD said. Some funds have been forced to sell at inopportune times in order maintain asset to liability ratios, and because of the major role pension funds play in some markets, this has had the effect of driving down prices even further.

The organisation has also called for better policy design for the pay-out phase of defined contribution (DC) systems. “Some of the default and mandatory arrangements in place are far from safe,” the OECD said.

The OECD added that to keep up with pension funding requirements after disappointing investment returns, many companies may be forced to increase their contributions to DB pension funds, which were already quite high as a result of recovery plans implemented after the 2000-02 stock market declines.

Some regulators have considered giving pension funds and their sponsoring employers more time to allow funding to return to target levels in order to avoid further strain on employers when the general economic situation is deteriorating.

For defined DC plans, the OECD believes there is going to be greater policy focus on appropriate default mechanisms and the design of “autopilot” funds (such as target-date or lifestyle funds) that shift towards lower risk investments as retirement date approaches without the member having to intervene.

In the context of the financial crisis and the rapid growth of DC plans, effective financial education programmes will also become more important to the proper functioning of the private pension system, the OECD said.