Alternatives Becoming Mainstream
JULY 26, 2012 • VIRGINIA MUNGER KAHN
By Virginia Munger Kahn
Driven by record low interest rates, volatile equity markets, and other cyclical and structural factors, institutional and retail investors are fueling strong growth in alternative investments. Last year, assets in hedge funds, private equity, real estate, commodities and infrastructure reached a record $6.5 trillion, according to a recent report from McKinsey & Company.
Despite poor performance, illiquidity and serious redemptions during the financial crisis, alternative assets grew at a 14.2% compound annual growth rate from 2005 through 2011. That compares to 1.9% growth for non-alternative investments.
"Alternatives survived the crisis and now are stronger than they were five years ago," said Onur Erzan, principal at McKinsey and co-author of the report titled, The Mainstreaming of Alternative Investments: Fueling the Next Wave of Growth in Asset Management. "Alternative investments are here to stay."
Besides cyclical factors such as low rates and market volatility, structural factors also are driving investors toward alternatives. For institutional investors, the desire to better match assets to liabilities has led many pension funds to increase allocations to fixed income securities. However, fixed income investments cannot generate the returns needed to pay benefits. Pension fund managers are turning to alternatives to generate increased alpha, according to Erzan.
That effort to align investments with income needs is also leading institutional investors to shift to absolute return investment frameworks. Financial advisors and individual investors are doing the same. According to McKinsey, 50% of advisors are managing client portfolios against an absolute return benchmark now. Alternative investments such as market neutral strategies are a good fit for such frameworks.
Seeking Diversification And Stability
Meanwhile, stung by the bear market of 2007-2009, and faced with underfunded retirements, retail investors are looking for investment options that promise better diversification and stable returns. Investment managers are obliging with new products that package alternative strategies into regulated funds.
The result is that both institutional and retail investors are increasing their allocations to alternative investments. In the U.S., institutional investors expect to have 28 percent of their portfolios allocated to alternative investments by the end of 2013, up from 26% in 2010, according to the report which is based on surveys of institutional investors, asset managers, registered investment advisors and other investment professionals.
Individual investors and their financial advisors are increasing allocations to alternatives as well. Retail alternative assets and strategies have grown by 21% annually since 2005 and now stand at about $700 million, according to McKinsey. By 2015, McKinsey figures retail alternatives will account for 13% of fund assets and about 25% of fund revenues versus 7% of assets and 13% of revenues in 2010.
This increased adoption of alternative assets by retail investors, the shift from relative return to absolute return benchmarks, and the convergence of traditional and alternatives managers and products in response to growing demand has resulted in what McKinsey terms the "mainstreaming" of alternative investments. This move into the investment mainstream will fuel the next phase of growth in alternatives.
There's no question that asset management firms are interested in moving into this space. Fully 100% of U.S. participants in McKinsey's survey said they believe alternatives will grow faster than traditional assets. Moreover, they can be expected to earn more on these assets than traditional products. Retail alternative investments can generate two to three times greater revenues than traditional mutual funds. Indeed, alternatives will account for a majority of retail revenue growth by 2015, according to McKinsey.
Still, alternatives present challenges not only for asset management firms, but for investors and financial advisors. One of the biggest challenges is integrating alternatives into traditional asset allocation models. Instead of allocating long/short hedge fund strategies to an alternatives category with illiquid real estate, for example, institutional investors increasingly group such investments with public equities. "It's not very intuitive," said Erzan. "This is an important opportunity for the industry to help investors map alternatives to standard approaches."
Equally challenging is communicating the value, risks and strategies of these investments to clients. "Some of the underlying strategies are sophisticated and you have to be able to communicate to clients without confusing them," noted Erzan.
The challenges for traditional players in the asset management industry are no less daunting. Many institutions and financial advisors are unwilling to allocate assets to managers who do not have an established track record-often, three years of performance. Asset management firms looking to take advantage of the growing demand for alternatives in the near term have little choice but to buy alternatives specialist firms or lift out specialist teams with established track records, said Kurt MacAlpine, associate principal at McKinsey and co-author of the report. Firms with a longer time frame can choose to build the expertise and track record, although there's no guarantee that will work, he noted.
Moreover, once such a team is in place, traditional firms face additional questions. How do these teams coexist with traditional asset managers who are compensated quite differently? How does the firm leverage the team's expertise to introduce new, integrated products? And, how do these products fit into the firm's existing sales process and capabilities?
Despite these challenges, investments in alternatives are expected to continue to grow strongly. Investment management firms will continue to be attracted by the opportunity to diversify their businesses and generate higher revenues. As far as financial advisors are concerned, said Erzan, alternatives provide "a lot of opportunity" to help clients navigate today's tough markets.