Investment Insights

Jeff Benjamin

Rise of alternatives should give advisers night sweats

As products proliferate, picking winners is more challenging than ever

Aug 9, 2014 @ 12:01 am

By Jeff Benjamin

The mutual fund industry must be licking its chops over a new McKinsey & Co. report that says all the right things for all the right reasons about the rosy future of alternative investments.

(In-depth: Our infographic breaking down the future of alts)

Among the highlights is a forecast that global alternative investments will nearly double by 2020, to $14.7 trillion. And though alternative investments are expected to represent just 15% of total global assets under management six years from now, they are forecast to account for 40% of asset management revenue.

The supply-and-demand fundamentals behind this soaring growth potential are described as both cyclical and structural — a fancy way of saying that nobody can think of a good reason not to focus on alternative investments.

Of course, as this column has underscored frequently, this is exactly the kind of news that should give financial advisers night sweats, because the category can no longer be ignored.

“There's a whole bunch of crap out there,” said Thomas Meyer, chief executive of Meyer Capital Group, in summarizing alts' rising popularity.

“Right now we're seeing five alternative funds and strategies come out every week, and it is total overload,” Mr. Meyer added. “Most of the funds are so new we haven't had any opportunity to know what they're even bringing to the table, because 90% haven't been battle-tested yet.”

RETAIL STANDS OUT

The McKinsey report, which was based in part on a survey of 300 institutional investors, covered the full landscape of alternative products and various investor classes. Retail investors stand out, though. They face a kind of alternatives revolution — largely because they are starting from a much smaller base of exposure.

Globally, the report counts assets held in retail-alternative-investment products at $2 trillion, up from $800 billion at the end of 2005. With a 12.6% compound annual growth rate over the past eight years, retail alternatives, or liquid alts, have been growing faster than hedge funds, private equity and real assets.

That pace is only expected to quicken, according to Ju-Hon Kwek, co-author of the report and an associate principal at McKinsey .

“We're expecting a fairly radical shift among retail intermediaries,” Mr. Kwek said. “The traditional thinking that portfolios should have a 5% allocation to alternatives is now getting closer to 20%.”

In the United States, assets in liquid alternative mutual funds tracked by Morningstar Inc. reached more than $300 billion through June 30, including $35.7 billion in net inflows over the first six months of the year.

The two fastest-growing of Morningstar's seven liquid alt subcategories are long-short equity, which had $9.3 billion in net inflows this year through June 30, and nontraditional bond funds, which had $20.7 billion in net inflows over the same period.

“We're seeing so much growth in retail alternatives because retail investors don't already have a lot of alternatives in their portfolios, and they know there's reason to be afraid of stocks and bonds right now,” said A.J. Dasaro, a Morningstar analyst.

For the general alternative investments camp, it doesn't hurt that the stock market is hovering near record highs and the bond market has been on a 30-year bull run, with interest rates poised to rise. But for the liquid alternatives space, it also doesn't hurt that pure alternatives such as hedge funds were tarred and feathered in the aftermath of the financial crisis for not doing their job while charging exorbitant fees.

In the aftermath of that experience, traditional hedge fund investors — institutions and really rich people — have become more likely to look toward the swelling bounty of liquid alternative mutual funds. And there you have yet another supply-and-demand nugget fueling the production of more registered products for financial advisers to sift through.

BLOOM OFF THE ROSE

“The bloom is off the rose with hedge funds because whether it's transparency, liquidity or lower fees, anything you can't get in the limited partnership world you can now get in the liquid alts world,” said Bradley Alford, chief investment officer at Alpha Capital Management.

Mr. Alford, who manages two registered funds of alternative funds, also is happy to help make the case for diversification within the liquid alts space by pointing out the extreme performance dispersions that occur in the alternatives universe.

Over the 10-year period through Dec. 31, 2012, the average annualized gap between top- and bottom-quartile performance of four popular hedge fund categories tracked by Hedge Fund Research Inc. ranged from 16 to 20 percentage points. That compares to top-to-bottom quartile dispersions of between 2.4 and 5 percentage points for large- and small-cap domestic stocks, international stocks and core fixed income over the same period.

“It's a lot more difficult to go out and pick individual alternative strategies, because you can get it really wrong,” Mr. Alford said.

And according to the folks at McKinsey & Co., that difficulty facing advisers on the due diligence side is only going to get more challenging because the fund industry's alternatives push is just getting started.

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