The Trillion-Dollar Convergence: Capturing The Next Wave Of Growth In Alternative Investments via McKinsey & Company

Executive Summary

Investment trends come and go, so it may be tempting to think of the current rush to alternatives as a passing fad. On the one hand, money has continued to pour into the category—which McKinsey defines to include hedge funds, funds of funds, private equity, real estate, commodities and infrastructure—over the past three years, with global assets hitting an all-time high of $7.2 trillion in 2013. And with their premium fees, alternatives now account for almost 30 percent of total industry revenues, while comprising only 12 percent of industry assets. Yet returns for many alternatives products have lagged the sharp gains of broader market indices in recent years, leading skeptics to contend that investor patience is wearing thin—and that the alternatives boom is about to run out of steam.

Alternative Investments

To the contrary, McKinsey research clearly indicates that the boom is far from over. In fact, it has much more room to run, as alternatives become increasingly entrenched in investor portfolios. Institutional investors—who control approximately 60 percent of the money flowing into alternatives – have not only upped their allocations to alternatives over the past few years, but the vast majority intend to either maintain or increase them over the next three years. Retail investors, meanwhile, are moving rapidly into the market, as new product vehicles provide unprecedented access to a broad range of alternatives managers and strategies. Structural, rather than cyclical, forces are accelerating the adoption of alternatives, chief among them the linking of alternatives to critical investment outcomes—a phenomenon that takes the value of alternatives strategies “beyond alpha.” Gone are the days when the sole attraction of alternatives was the prospect of high-octane performance. The market meltdown caused by the global financial crisis, coupled with the extended period of volatility and macroeconomic uncertainty that followed, have left their marks, and investors are now turning to alternatives for consistent, risk-adjusted returns that are uncorrelated to the market. They are also increasingly looking to alternatives to deliver on other crucial outcomes like inflation protection and income generation.

Alternative Investments

For asset managers, the continued rise of alternatives represents one of the largest growth opportunities of the next  five years. And in stark contrast to traditional asset management, the alternatives market remains highly fragmented, with ample room for new category leaders to emerge. Within the hedge fund and private equity asset classes, for instance, the top five firms by global assets collectively captured less than 10 percent market share in 2012—a far cry from the 50 percent share enjoyed by the top five firms competing in traditional fixed-income and large-cap equity. The competitive landscape is also rapidly evolving. The mainstreaming of alternatives is now driving a “trillion-dollar convergence” of traditional and alternative asset management. Leading hedge funds, private equity firms and traditional asset managers—which to date have occupied distinct niches in the investment management landscape—will increasingly battle for an overlapping set of client and product opportunities in the growing alternatives market.

Alternative Investments

This report draws on the findings of McKinsey’s 2013-2014 Alternative Investment Survey, which polled nearly 300 institutional investors managing $2.7 trillion in total assets and included more than 50 interviews with a cross section of investors by size and type. It also builds on McKinsey’s ongoing research into the growth of the retail alternatives market and the insights published in our 2012 report, The Mainstreaming of Alternative Investments.

Alternative investments: Key findings

Key findings from our most recent research include the following:

  • Over the next five years, net flows in the global alternatives market are expected to grow at an average annual pace of 5 percent, dwarfing the 1 to 2 percent expected annual pace for industry as a whole. By 2020, alternatives could comprise about 15 percent of global industry assets and produce up to 40 percent of industry revenues.
  • The next wave of growth in alternatives will be driven disproportionately by a “barbell” comprised of large, sophisticated investors who are experienced alternatives investors and smaller investors who are “first-time buyers.” Specifically, flows to alternatives from four segments of investors—large public pensions and sovereign wealth funds, smaller institutions and high-net-worth/retail investors—could grow by more than 10 percent annually over the next five years.
  • Growth in alternatives is playing out as “a tale of two cities,” with divergent investment priorities and manager preferences emerging across different investor segments. Larger, more sophisticated investors (e.g., institutions with more than $10 billion in assets under management [AUM]) reveal a clear bias towards specialist investment managers and alternatives boutiques that offer unique insights and market exposures. At the other end of the spectrum, smaller, less established investors (e.g., those with under $2 billion in AUM and core retail channels) have a strong preference for the breadth and stability of larger managers and the comfort of established brands.
  • Liquidity preferences are evolving and reshaping product priorities. Hedge funds and other liquid alternatives will continue to experience robust demand from virtually all investor types. But larger, more sophisticated investors will invest further down the liquidity spectrum, with the vast majority planning to increase their allocations to more specialized private-market asset classes—real estate, infrastructure, and other real assets such as agriculture and timber— over the next three years.
  • Retail alternatives will be one of the most significant drivers of U.S. retail asset management growth over the next five years, accounting for up to 50 percent of net new retail revenues. In addition to growth in institutional alternative strategies and vehicles, McKinsey expects absolute return, long/short and multi-alternative strategies in mutual fund formats to grow disproportionately over the next two to three years. New product development and smart distribution will remain critical to capturing growth opportunities and market share in the retail alternatives market.

Alternative Investments

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