With every alternative asset growing in the recent past, global assets under management of alternatives grew at an annualized 10.7% between 2005 and 2013, which is twice the rate of traditional investments, notes a McKinsey study.

After surveying nearly 300 institutional investors managing $2.7 trillion in total assets, Pooneh Baghai, Onur Erzan and Ju-Hon Kwek of McKinsey in a report titled: “The $64 trillion question: Convergence in asset management” point out that alternatives have enjoyed this growth at a time when their returns have generally lagged behind the broader market indexes.

Boom in alternative investments

According to the McKinsey report, every alternative asset grew, especially direct hedge funds, real assets and retail alternatives sold through registered vehicles like mutual funds and ETFs. Moreover, private equity, where assets retreated from pre-crisis highs, too also bounced back in its new fund-raising. As can be seen in the following graph, assets hit a record high of $7.2 trillion in 2013, with the category doubling in size since 2005. The burgeoning growth in the industry is evident as net flows into alternatives were 6% of total assets in 2013, dwarfing the 1 to 2% rate of non-alternatives.

Growth of alternatives

Baghai et al. points out that despite alternatives’ returns generally lagging behind the market indexes, their research indicates that the boom is far from over and investors’ patience isn’t wearing thin. They point out that investors are still showing keen interest, including large and small pension funds and sovereign-wealth funds. With wealthy individuals also moving rapidly into the market, the McKinsey team believes flows from each of these four groups could grow by over 10% annually over the next five years.

The McKinsey team highlights that four secular factors aided the rush into the alternatives viz.: disillusionment with traditional asset classes and products, evolution in state-of-the-art portfolio construction, increased focus on specific investment outcomes, and a hard-to-close gap with many of the defined-benefit pension plan sponsors placing their faith in higher-yielding alternatives.

Retail segment to drive alternatives growth

According to the report, the retail segment will be a primary driver of alternatives growth, particularly in the U.S. It notes the broad category of retail alternative assets, including alternative-like strategies such as commodities, long-short products, and market-neutral strategies in mutual fund, closed-end-fund, and ETF formats have grown by 16% annually since 2005. As set forth in the following graph, the growth has been broad based across alternative asset classes, with direct hedge funds and retail alternatives accelerating fastest:

Broadbased growth

The report notes there is a divergent set of needs emerging among large and small investor segments. For instance, institutions managing over $2 billion are moving down the liquidity spectrum to embrace more specialized private-market exposures, especially to real assets. The analysts point out that two-thirds of these investors indicated that they plan to enhance allocations to agriculture, energy, infrastructure, real estate and timber.

As captured in the following table, in contrast to their larger peers, smaller investors are drawn to large managers because of their established brands, ability to deliver across a broad range of alternative asset classes, and their robust operational and compliance infrastructures:

Different needs among small and large institutions

Alternatives market is highly fragmented

In stark contrast to traditional asset management, the alternatives market remains highly fragmented, with ample room for new category leaders to emerge. The graph below shows that, within the hedge-fund and private-equity asset classes, the top five firms by global assets collectively captured less than 10% market share in 2012, which is a far cry from the 50% share garnered by the top five firms competing in traditional fixed-income and large-cap equity:

Alternatives-highly fragmented

Finally, Baghai and colleagues note that traditional asset managers have used their distribution reach to achieve a first-mover advantage in the market for alternatives mutual funds and ETFs. Interestingly, 18 of the 20 largest retail alternatives funds in 2013 were run by traditional asset managers. The report notes with the stakes so high, competition between traditional managers and alternatives specialists will only intensify. The analysts also suggest a wave of partnerships or joint ventures between traditional and alternatives firms is possible.