McKinsey survey highlights convergence of traditional and alternative managers

07 Aug, 2014

The convergence between alternatives and traditional asset managers looks set to continue with liquid alternative mutual funds likely to account for up to 50% of net new retail revenues over the next five years, according to a report by McKinsey & Co.

The report – “The Trillion-Dollar Convergence: Capturing the Next Wave in Alternative Investment”, which surveyed 300 institutional investors, said there would be disproportionate growth in absolute return, long/short and multi-alternative strategies in mutual fund or exchange traded fund (ETF) formats over the next two to three years.  The McKinsey paper highlighted mutual fund assets in hedge funds had grown ten-fold since 2005, and now accounts for $308 billion.  

The McKinsey study said net flows into alternative investment products would grow at an average annual pace of 5%, dwarfing the one to two per-cent many had predicted. McKinsey’s study said that by 2020, the $7.2 trillion alternatives space could comprise 15% of global fund management assets, and produce nearly 40% of industry revenues.  

Investors are increasingly embracing these products in order to avoid correlated returns amid widespread market volatility, while others – mainly plan sponsors – are simply trying to meet their ever growing liabilities by investing into higher yield products.  

“A  growing pool of investors is gravitating towards the notion of “bar-belling” in their investment portfolios; that is, complementing the low-cost beta achieved through index strategies with the “diversified alpha” and “exotic beta” of alternatives. Many of the most sophisticated institutions are beginning to abandon traditional asset-class definitions and embrace risk-factor based methodologies, a trend that repositions alternatives from a niche allocation to a central part of the portfolio. Hedge funds, for instance, are now considered by a growing number of these investors to be part of a larger pool of equity and fixed-income allocations,” read the report.

The growth of liquid alternatives is well-documented with an increasing number of hedge funds launching products compliant the 1940 Investment Company Act (’40 Act). A study – “Developments and Opportunities in the ’40 Act Space’ - by Barclays Prime Services said assets in liquid alternatives grew by 43% in 2013 while hedge funds saw their assets increase by just 15%.  A growing chorus of service providers are predicting substantial growth in liquid alternatives. The Barclays study estimates the liquid alternatives space will grow from $137 billion today to anywhere between $650 billion and $950 billion by 2018. Likewise, Citi Prime Finance estimates liquid alternatives will manage $939 billion by 2017.

Managers themselves are sufficiently bullish. Ninety per-cent of managers told the Barclays survey they expected at least ‘moderate’ growth in 40 Act products. A Deutsche Bank Markets Prime Finance survey of 60 hedge funds with collective Assets under Management (AuM) of $528 billion in December 2013 found nearly half were already running a traditional long-only product. The driver behind this growth is primarily retail investor interest.

However, detractors of liquid alternatives routinely point out these vehicles underperform hedge funds. While this is true to an extent, 40 Act products managed by hedge fund managers delivered an annualised return of 1.6% over the last six years, just shy of the 2.3% posted by the average hedge fund. This does raise awkward questions about some of the fees being charged by hedge fund managers given that they are far higher than their alternative mutual fund counterparts. 

The distribution opportunities for liquid alternatives are potentially enormous. Barclays highlighted there was approximately $19 trillion in assets up for grabs from defined contribution (DC) pension schemes, individual retirement accounts, annuity reserves, broker-dealers and registered investment advisers (RIAs). One of the key investor targets among managers running regulated alternatives will be the DC plans.  A report in 2013 by SEI said 60% of the DC plan market’s $5.1 trillion in assets was parked in mutual funds, adding this investor class had historically been averse to alternatives although hinted this could change.

Others argue excitement about liquid alternatives is overhyped, pointing out that growth in absolute return UCITS vehicles In Europe has been sluggish, while 130/30 funds faded into oblivion during the financial crisis. The Barclays study attributes the sluggish growth in UCITS to simple supply and demand issues. Investors often believe UCITS routinely underperform hedge funds. Furthermore, the DC pension market in Europe is limited making it harder for absolute return UCITS to grow their asset base. In addition, private banks and wealth managers in Europe have retreated from hedge fund investing and are yet to re-enter the alternatives market en masse.

There are a number of serious impediments that could also stifle the emergence of liquid alternatives in the US. While the distribution benefits are hard to falter, 40’ Act hedge funds are subject to onerous restrictions. The absence of leverage (capped at 33% of gross assets), lack of performance fees (with a management fee of between 70 basis points (bps) and 1%), restrictions on investing in illiquid assets (capped at 15% of AuM), rigorous corporate governance standards and mandatory third party custody will all lead to higher compliance costs, at a time when profits are rapidly receding. These restrictions will also make it prohibitively expensive for smaller and mid-sized hedge funds to fully embrace liquid alternative structures. 







McKinsey & Coconvergenceliquid alternatives'40 ActBarclaysDeutsche BankSEI