By Virginia Munger Kahn

Driven by record low interest rates, volatile equity markets, and other cyclical and structural factors, institutional and retail investors are fueling strong growth in alternative investments. Last year, assets in hedge funds, private equity, real estate, commodities and infrastructure reached a record $6.5 trillion, according to a recent report from McKinsey & Company.

Despite poor performance, illiquidity and serious redemptions during the financial crisis, alternative assets grew at a 14.2% compound annual growth rate from 2005 through 2011. That compares to 1.9% growth for non-alternative investments.

"Alternatives survived the crisis and now are stronger than they were five years ago," said Onur Erzan, principal at McKinsey and co-author of the report titled, The Mainstreaming of Alternative Investments: Fueling the Next Wave of Growth in Asset Management. "Alternative investments are here to stay."

Besides cyclical factors such as low rates and market volatility, structural factors also are driving investors toward alternatives. For institutional investors, the desire to better match assets to liabilities has led many pension funds to increase allocations to fixed income securities. However, fixed income investments cannot generate the returns needed to pay benefits. Pension fund managers are turning to alternatives to generate increased alpha, according to Erzan.

That effort to align investments with income needs is also leading institutional investors to shift to absolute return investment frameworks. Financial advisors and individual investors are doing the same. According to McKinsey, 50% of advisors are managing client portfolios against an absolute return benchmark now. Alternative investments such as market neutral strategies are a good fit for such frameworks.

Seeking Diversification And Stability
Meanwhile, stung by the bear market of 2007-2009, and faced with underfunded retirements, retail investors are looking for investment options that promise better diversification and stable returns. Investment managers are obliging with new products that package alternative strategies into regulated funds.

The result is that both institutional and retail investors are increasing their allocations to alternative investments. In the U.S., institutional investors expect to have 28 percent of their portfolios allocated to alternative investments by the end of 2013, up from 26% in 2010, according to the report which is based on surveys of institutional investors, asset managers, registered investment advisors and other investment professionals.

Individual investors and their financial advisors are increasing allocations to alternatives as well. Retail alternative assets and strategies have grown by 21% annually since 2005 and now stand at about $700 million, according to McKinsey. By 2015, McKinsey figures retail alternatives will account for 13% of fund assets and about 25% of fund revenues versus 7% of assets and 13% of revenues in 2010.

This increased adoption of alternative assets by retail investors, the shift from relative return to absolute return benchmarks, and the convergence of traditional and alternatives managers and products in response to growing demand has resulted in what McKinsey terms the "mainstreaming" of alternative investments. This move into the investment mainstream will fuel the next phase of growth in alternatives.