Asset Allocation Outlook
Alternatives bring AID (alpha, income, diversification) to the traditional asset portfolio
It’s been a year marked by shortages – toilet paper, hand sanitizer, even flour. In 2020, we all learned that replacing paper towels with reusable kitchen rags is both efficient and sustainable. Faced with shortages, we look for items that have the potential to create similar and possibly better outcomes. Applying this concept to the markets today, investors can address shortages of alpha, income and diversification (AID) in traditional portfolios by adding alternatives. In this way, they can realize better investment outcomes.
On the heels of unprecedented, pandemic-driven fiscal and monetary policy intervention, our 2021 Long-Term Capital Market Assumptions forecast an annual 4.2% return from a 60/40 portfolio over the next 10 to 15 years.1 Today, at the start of a new cycle, public markets are challenged by yields at all-time lows and stretched valuations – a highly unusual occurrence. In this context, alternatives and active management stand out as the two sources of AID investors need to succeed, in both the near term and the long term.
Cycle-aware allocations can enhance alpha, income and diversification
Utilization of this AID requires precision and discipline. Too often, investors assemble a collection of alternative assets without giving enough consideration to how the allocations will work together in a portfolio. This lack of foresight can prove damaging in portfolio construction. We believe that a strong alternatives framework is essential to building resilient portfolios. Alternative asset portfolio construction should be a holistic process with an emphasis on investment attributes. Focus on what assets do rather than what they’re called. For instance, as shown in EXHIBIT 1, the alternatives core foundation provides stable income with lower volatility. Core complements provide added diversification and/or differentiated returns. And return enhancers deliver just what the name implies. Similarly, fixed income-like and equity-like alternatives on the left and right, respectively, solve for enhanced outcomes vs. those public markets. Hybrids represent all-season asset classes (such as hedge funds and real assets) that have both fixed income and equity-like attributes.
Our 2020 outlook2 emphasized that we were in the late stages of the previous market cycle. (Of course, we did not imagine that a global pandemic would spark widespread lockdowns and a sharp recession.) Last year, we highlighted the use of all-season hybrids that either provide resilience via core real assets or capture dislocation via hedge funds and special situations. We pointed to core foundation credit as a source of added protection and private equity as a return enhancer that would position investors to benefit when the cycle turned. All of these positions held up well vs. lower quality credit, or non-core hard assets, which were de-emphasized (EXHIBIT 1A).
Early in the pandemic (EXHIBIT 1B), we made the case for allocating new capital to fixed income-like alternatives at both the higher quality and the distressed ends of the spectrum, where we saw considerable dislocation. We also liked actively managed low volatility core equity such as hedged equity and all-tranche REITs, while maintaining an emphasis on all-season hybrids in the form of hedge funds and special situations, which benefit from volatility and dislocation.
Our opportunity set shifted significantly over the past year
EXHIBIT 1: THE ALTERNATIVES SOLUTIONS BUILDING BLOCKS
2021: Current early-cycle positioning
In November, news of successful COVID-19 vaccine trial results led us to our post-pandemic 2021 view (EXHIBIT 1C), which coincidentally looks like the Red Cross first aid symbol. An AID approach may be especially helpful in today’s market environment, when investors’ need for alpha, income and diversification is more pronounced.
Post-pandemic alpha: All segments of the core complements look well positioned to deliver enhanced returns. Those returns may come from spread and yield compression in the less trafficked, disrupted segments of alternative credit. Or we may see normalization-driven risk premia compression in value-add real assets or in return-enhancing special situations plays focused on the service economy. Rising volatility, dispersion and ESG (environmental, social and governance) integrated diligence could continue to create a “Goldilocks” environment for hedge fund alpha generation.
Post-pandemic income: In essential assets such as core real assets, investors can find stable income streams generated by long-term contractual cash flows that can, in most cases, grow with inflation. With traditional fixed income yields at all-time lows, core real assets look mispriced vs. fixed income, as their yields have held up well in the pandemic. Normalization should compress their risk premia further. High quality core real estate globally looks especially attractive in this environment.
Post-pandemic diversification: Today, many segments of fixed income have become less effective as volatility dampeners and diversifiers. In such an environment, hybrid asset classes such as hedge funds and real assets can boost diversification. Hedge funds, with their ability to short, can be quite effective when quality, sector and regional dispersion is on the rise. As a result, they are well suited to provide uncorrelated return streams that benefit from equity volatility. Tangible hybrid high quality assets, such as core real assets, offer exposure to local uncorrelated economic factors, underpinned by stable income, with the potential to grow those income streams. They provide another important tool investors can use for public equity diversification.
When paper towels were nowhere to be found, kitchen rags came to our rescue. A similar sort of flexibility powers the growing use of alternatives in multi-asset portfolios. Indeed, the AID from alternatives is accelerating their transition from optional to essential portfolio components. Alternatives can be used for both re-risking and de-risking, and today alternative assets offer very attractive risk premia across the board. We encourage investors to use this early-cycle window to take advantage of the alpha opportunities arising from pandemic dislocation, while building in income, diversification and portfolio resilience. A strong investment framework will include outcome-driven insight and analytics-based allocations. That will bolster investors as they look to alternatives for the alpha, income and diversification they need.
1 Source: J.P. Morgan Asset Management; data in USD, as of September 30, 2020.
2 Source: 2020 Alternatives Outlook, J.P. Morgan Asset Management, January 2020.