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Should You Believe the Hype?

Debunking the hubris surrounding alternative investment growth.  

Nadia Papagiannis, CFA, 08/02/2012

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.

Fuzzy Math
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.

Even though advisors have been eager to adopt alternatives, liquid alternative fund providers are not going to reach 10%-15% market share through advisors. As evidenced by ebbing flows, advisors' eagerness has subsided, most likely because they are confused as to how to use alternatives. Jackson National Life's 2012 Elite Access Alternative Investment Survey of 2190 financial advisors found that, while 95% of advisors expected their usage of alternative asset classes to increase over the next year, 53% felt that guidance was very important. They needed the support from a third-party asset manager when building their client's portfolio, and 78% were more likely to use alternatives offered within a guided strategy.3 The study was conducted to support Jackson's new alternative variable annuity product, which was designed to be a partial solution to a much larger conundrum: retirement.

The Holy Grail of Investment Assets
Retirement solutions are the name of the game for liquid alternative providers. The bulk of mutual fund dollars are in 401(k) or other retirement accounts. Retirement savings accounted for 36% of the $18.9 trillion U.S. household financial assets as of March 31, 2012, according to the ICI. IRAs and defined contribution plans made up $5.2 trillion and $4.8 trillion of those assets, respectively. Mutual funds managed 46% of IRA assets and 58% of defined contribution assets, and target-date funds represented a rapidly growing share.4 To the extent that alternative mutual fund and ETF sponsors can access retirement dollars and can provide investment solutions, such as target-date funds, rather than siloed products, for plan participants, they will build market share.

Unfortunately, the retirement market has been a difficult area to penetrate. Target-date funds, which are the qualified default investment alternative in a growing number of retirement plans due to their one-stop-shop portfolio solution and ease of use, currently hold miniscule if any allocations to alternative strategies, according to Morningstar's Target-Date Series Research Paper 2012 Industry Survey. As pension funds continue to move to defined contribution, target-date funds will increase in importance. In order to grow dramatically, liquid alternatives will have to find a way into target-date fund lineups.

What Happened to Hedge Funds?
Despite all of the studies predicting amazing anticipated growth in liquid alternative assets, surveys catering to nonliquid hedge fund providers also predict rapid growth. The Hedge Fund Research Global Hedge Fund Industry Report, for example, states that total capital in the global hedge fund industry increased to $2.13 trillion at the end of the first quarter of 2012, an all-time record level of assets.5 The 2012 KPMG/AIMA Hedge Fund Survey study cited a hedge fund manager who believes that "There will definitely be higher industry AUM in three years. Money will continue to come in. Hedge funds will continue to grow."6

Well, not according to our data. Morningstar's database, which houses over 5,000 single-manager hedge funds and about 2,500 funds of funds, has experienced asset stagnation since 2008. Historical quarterly assets peaked at $557 billion in June of 2008 and rest at $320 billion as of March 2012. The picture for funds of funds is even worse--they have steadily lost assets since 2008.

While we don't believe hedge funds and other private pools are going away (institutions continue to invest in the largest hedge funds, many of which do not report to any databases), we expect these funds to continue to move into the liquid retail arena. AQR, a multi-billion-dollar hedge fund firm, was one of the first entrants into the retail mutual fund market post-2008 crisis, and KKR, one of the largest private equity firms, debuted its first retail offerings in July of this year. The JOBS Act, which allows for more widespread marketing of private pools, will likely augment this private/retail product convergence trend, because the vast majority of investors viewing any advertisements will not be accredited.

Should We Be Investing More in Liquid Alternatives?
Given the vast number of liquid alternative products now available to advisors and retail customers, the question is, "Do we really need them?" The answer is "yes"--but not all of them. Institutional and advisor participants in Morningstar's survey aptly identified diversification as the primary reason to invest in alternatives, and both parties cited lack of liquidity as one of their top hesitations. In a risk-on/risk-off world where equity and credit risk are highly correlated, and a low-interest-rate environment that means lower returns over the long run, our portfolios need all the help we can get. But to rush into liquid alternative products wholeheartedly without vetting the pros and cons would be foolish. Obviously, not all of them will perform as advertised. In fact, since 2008, many of them haven't. That is why Morningstar has started to cover alternatives in depth.

In June, Morningstar released long-form reports and ratings on more than 40 alternative mutual funds, which comprise 75% of total alternative mutual fund assets, and we expect to double this number in the near future. Our ratings tell investors which funds we like going forward in each category. And to help investors use these funds properly in a portfolio, we have created a suite of educational material available on Morningstar Advisor. The moral of the story is that interest alternative investments, particularly in liquid vehicles, should grow, but only for the right reasons.

 

[1] The Mainstreaming of Alternative Investments: Fueling the Next Wave of Growth in Asset Management. McKinsey & Company Financial Services Practice, June 2012.

[2] "Alternative investment strategies set for rapid growth, Cerulli says." Jeff Benjamin, Investment News, July 22, 2012. http://www.investmentnews.com/article/20120722/REG/307229977

[3 ]2012 Elite Access Alternative Investment Survey. Jackson National Life Insurance Company, May 2012.

[4] http://www.ici.org/research/retirement/retirement/ret_12_q1

[5] "Hedge Fund Assets Surge to Record Levels on Strong 1Q Gains." Hedge Fund Research Inc., April 19, 2012. http://www.hedgefundresearch.com/pdf/pr_20120419.pdf

[6] The Evolution of an Industry: 2012 KPMG/AIMA Global Hedge Fund Survey. KPMG International Cooperative, May 2012.

Nadia Papagiannis is an analyst with Morningstar.
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