Debunking the hubris surrounding alternative investment growth.
The investing world has come down with alternatives fever. At least six surveys have been published in the first half of 2012 (McKinsey & Company, Jackson National Life, and Cerulli, to name a few), all of them banging the drum for alternative investments, in terms of current and potential asset growth and revenue generation, especially for liquid vehicles. The McKinsey study,1 for example, predicts that "By 2015, retail alternatives will likely account for 13% of U.S. retail fund assets and approximately one quarter of revenues." Cerulli's forecast is only slightly more conservative, positing that alternative mutual funds could represent 9.7% of mutual fund assets in five years.2
These claims can be characterized as optimistic at best. While it's true that more and more investors are adopting alternative investments, and that there is a trend toward more-liquid vehicles, the way we currently invest is not going to do an about-face in a few years--nor should it.
The State of the Union
To predict the prominence of alternative investments in five years, one needs an understanding of where we are today. As of Morningstar's June 30 count, there are $8.6 trillion in mutual fund (excluding money market funds) assets in 94 different categories. Morningstar considers seven of these 94 categories alternative: bear market, currency, long-short equity, managed futures, market-neutral, multialterantive, and nontraditional bond. These seven alternative categories represent only $107.4 billion, or just over 1% of total mutual fund assets. That's a far cry from the 10%-13% market share predicted above.
Sure, it's possible that assets in alternative funds could grow at least tenfold in three to five years. But it's highly unlikely. Just look how long it's taken to get to where we are today. Five years ago, the same seven categories of alternative mutual funds represented just over one half of 1% of total mutual fund assets ($39.4 billion of $7.4 trillion total mutual fund assets as of June 30, 2007). So the market share has doubled in five years. The trajectory will not likely be as strong going forward, because since 2011, flows have begun to slow. In 2010, flows into alternative mutual funds peaked at a record $45.4 billion, but declined to $24.2 in 2011. So far in 2012, the flows have barely reached $2.8 billion. The sense of urgency, namely the financial crisis and a fear of a spike in interest rates, has passed, and investors are now thinking with a clearer mindset.
Rather than looking at alternative mutual funds, one might instead look to exchange-traded funds as the fuel for liquid alternative investment growth. Total U.S. ETF assets stood at nearly $1.2 trillion as of June 30. Combining the assets of six of the same seven aforementioned alternative categories (nontraditional bond ETFs don't exist due to a moratorium on derivatives use), and adding volatility (these strategies reside primarily in ETFs at the moment), total alternative ETF assets stand at only $9.8 billion, less than 1% of total ETF assets. The growth story for alternative ETFs is the same as for mutual funds, with assets and inflows peaking prior to 2011.
Of course, no one data or survey provider uses the same definition of alternatives. If we included futures-based commodity ETFs in our alternative asset count (which we typically do), these would only add another $106 billion to the mix. Most of these assets ($65 billion) reside in a single ETF, the SPDR Gold Shares GLD, one of the two largest ETFs. There is obviously a limit to how much more GLD can grow.
If we added (and we typically do) the leveraged and inverse strategies, one of the rapid-growth areas in ETF-land, this would still increase our alternative asset count only another $28 billion. Although our alternative ETF asset total is now about $145 billion, and 12% of ETF assets, it's still not likely that we will see alternative's retail market share grow to 10%-15% of total retail assets in the near future through ETFs. Mutual funds reign as the preferred vehicle of advisors, who are the consumers adopting alternatives.
Who Uses Liquid Alternatives?
According to ICI data (available on Morningstar DirectSM), the "nonproprietary" distribution channels, or advisors, make up the bulk of alternative mutual fund flows. According to the Morningstar & Barron's 2011 Alternative Investment Survey of U.S. Institutions and Financial Advisors, mutual funds are the preferred access vehicle for every possible variety of alternative investment strategy with the exception of private equity, private debt, and private real estate (because mutual funds have restrictions on illiquidity), as well as leverage and volatility (because these are shorter-term trading strategies). After mutual funds, ETFs are the preferred vehicles. Advisors are the driver behind ETF growth in general, not just alternative ETFs.