Hedge funds once had the allure of being high octane and exotic. Today, they have a reputation of being mundane and consistent.
That is why investors are putting more money than ever into them, according to a new McKinsey & Company report published on Wednesday called “The Trillion-Dollar Convergence: Capturing the Next Wave in Alternative Investment.” The report’s findings are based on a survey of nearly 300 institutional investors.
Those investors said they were happy to settle for steady and sometimes lower-than-average returns as they sought investments that would not be affected by a sudden downturn in equity markets or a shift in the current low interest rate environment.
“That is a bit of a transition or switch from what the perception of hedge funds was six years ago when they were viewed as high risk,” said Onur Erzan, a senior partner in McKinsey’s global wealth and asset management practice and one of the lead authors of the report.
In the $7.2 trillion global alternatives universe, which includes real estate, commodities and private equity firms, hedge funds are the fastest-growing category, ballooning in size to $2.6 trillion at the end of 2013 from $1.4 trillion in 2008.
This flood of money — which McKinsey says will grow by 5 percent annually over the next five years — represents “one of the largest growth opportunities of the next five years.”
Strong flows into the industry have been a boon to firms like the publicly listed Och-Ziff Capital, which on Tuesday announced in its quarterly earnings report that its assets under management had reached a record $45.9 billion.
“Globally, we believe that pension funds and other institutions will continue to increase their allocations to alternative asset managers,” said Daniel S. Och, chairman and chief executive of Och-Ziff, adding that the firm would be a “substantial beneficiary” of the trend.
Still, hedge funds still face frustrated investors complaining of years of lackluster performance and high fees.
For five consecutive years, hedge fund performance has lagged the Standard & Poor’s 500-stock index, according a composite index of 2,200 portfolios tracked by HFR.
Last year, the average fund returned just 9.1 percent, according to HFR, compared with a 32.4 percent gain in the S.&P. 500, after accounting for dividends. Despite lower returns, managers continue to charge high management and performance fees.
Hedge fund typically use a “2 and 20” model, charging investors 2 percent of total assets for management fees and 20 percent of the profits each year.
The McKinsey report also found that institutional investors who manage money for pension plans are moving more money into alternatives “out of desperation” because they are limited in their options for investments that offer a yearly rate of return that is high enough to continue funding their plans.
As more money rushes into hedge funds and other alternative firms, the biggest effect will be consolidation of firms, the report says.
“We are seeing the growth and increasing dominance of what we call the mega alternatives,” Mr. Erzan said. Investment firms like Carlyle, Kohlberg Kravis Roberts Blackstone and Apollo have already grown into giants in the industry.
The fastest-growing category of hedge fund investors, meanwhile, is individual retail investors, who are dipping their toes into new “liquid alternatives” — mutual funds that invest in hedge fund strategies.