Positive for ILS investing: McKinsey says alternatives to keep growing

by Artemis on August 21, 2014

One of the factors that is responsible for assisting the rapid growth of the insurance-linked securities (ILS) and reinsurance-linked investments market in recent years is global investors continuing shift towards alternative asset classes.

Globally, institutional investors, such as pension funds, endowments and foundations, sovereign wealth funds, insurers and cash-rich corporates, have been pouring capital into alternative asset classes as they look for sources of return which complement their strategies and bring certain qualities to their portfolios.

One of the qualities that an asset class such as insurance-linked securities (ILS) or an investment in catastrophe bonds offers to these investors is a low-correlation with the broader financial markets. Many alternative investments offer some level of decorrelation for the institutional investors portfolio, but ILS and reinsurance linked investments offer one of the greatest decorrelation opportunities in the alternatives world.

Consultancy McKinsey published a report on the growth of the alternative investments market recently, a sector it deems to include hedge funds (where ILS funds would fit), funds of funds, private equity, real estate, commodities and infrastructure.

Over the last three years the attraction of alternative asset classes has grown rapidly, with some $7.2 trillion of assets in alternatives by the end of 2013. Given their premium management fees, alternatives now account for almost 30% of investment industry revenues, despite comprising only 12% of industry assets.

However, alternatives returns have lagged behind some major market indices in recent years, with stocks seeing some very strong recoveries after the financial crisis. As a result, although alternatives provide a good return, some have commented that the flow of capital into alternative asset classes is set to wane.

McKinsey doesn’t agree. It’s research suggests that rather than waning, the cash flows into alternatives are set to continue and perhaps even grow, as an increasing number of investors discover the qualities of alternative asset classes and alternatives become increasingly entrenched in investor portfolios.

The boom in alternatives is set to run, says McKinsey, in fact alternative asset classes are set to become much more entrenched in institutional investor portfolios. 60% of the money flowing into alternatives currently comes from institutional sources and the majority of the investors behind this intend to increase their allocations to alternatives in the years to come.

At the same time retail investors are also getting a taste for the alternative, with vehicles being set up to give retail investors access to more exotic asset classes, which again alternatives are set to benefit from.

It is structural, rather than cyclical, forces which are helping to drive money into alternatives, says McKinsey. The prime reason for the shift is that growing realisation and perception that alternatives are strongly linked to investors critical outcomes, taking the value of alternatives beyond simply alpha.

We’re now passed the day where alternatives are simply seen as a portfolio boosting return opportunity. Investors are looking for specific asset qualities which can provide a complement to their overall institutional, or retail, portfolio, a topic we’ve written about before with reference to insurance-linked securities (ILS) and catastrophe bonds.

“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,” explains McKinsey.

This is why we have written extensively in the past that the mainstream media pigeon-holing of ILS and cat bond investors as “yield hungry” is plainly inaccurate. If indeed that was correct then almost every institutional investor could be labelled yield hungry for investing in any alternative asset class, especially as ILS and cat bonds is not even the highest yielding. That simply is a hunt for headlines and readers unfortunately and if they took the time to look at the entire alternatives universe it would very quickly be seen that ILS is a very small piece of this growing pie.

McKinsey says that the growth of the alternative asset presents investment managers with one of the largest growth opportunities of the next five years. The category remains fragmented, which leaves room for new market leaders to emerge, either as specialists in a single asset class or as alternatives generalists.

McKinsey further highlights the opportunity this presents; “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.”

Key findings of McKinsey’s report include:

  • Over the next five years, net flows in the global alternatives market are expected to grow at an average annual pace of 5%. By 2020, alternatives could comprise about 15% of global investment industry assets and produce up to 40% 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% 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.
  • Traditional and alternative asset management will continue to dovetail, leading to a “trillion-dollar convergence.” Four successful alternatives manager archetypes will emerge in this environment, each with a distinct value proposition: diversified asset managers, multi-alternative mega firms, specialist alternatives platforms and single-strategy boutiques. While specialist firms will continue to play a significant role in the alternatives industry, McKinsey expects ongoing share gains by larger, at-scale managers, as the industry continues to mature.

To sum up, McKinsey believes that the alternatives boom is here to stay and built to last. This bodes well for the insurance linked asset class, so ILS, catastrophe bonds, insurance and reinsurance linked funds and other vehicles which can give investors direct access to the risk/return of insurance and reinsurance business or contingent risk financing.

The growth we’ve seen in the ILS asset class over the last year is partly as a result of the increasing knowledge and understanding of the asset class among certain large institutional investors. As more and more investors begin to explore the alternatives space, ILS and catastrophe bonds are sure to be highlighted, as examples of low-correlation, stable return, diversifying assets.

As a result we’d expect any continued growth in alternatives to result in growth for ILS and catastrophe bonds, or other future structures and vehicles. It boils down to the asset qualities we’ve written about before. Investors are increasingly seeking exactly these qualities, something which the ILS asset class can provide in spades – diversifying, stable returns with low-correlation and credit risk – which we believe equals a bright future as the investment management world becomes increasingly alternative.

Other articles on the growing popularity of alternative asset classes and how ILS, catastrophe bonds and insurance linked investments can benefit from this trend:

Japan’s pension funds target investments in riskier assets, ILS included.

Sovereign wealth funds look to alternatives, ILS expected to feature.

ILS and cat bond investors. Yield hungry? Or seeking asset qualities?

Insurance linked investments outlook bright as hedge fund assets grow.

Insurance linked securities see strong demand as alternative investment: PwC.

Pension funds still only dipping their toes into ILS and reinsurance.

Hedge funds to see strong institutional inflows, good for ILS funds.

Reinsurance as an alternative continues to appeal to multi-asset funds.

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