A strategic framework for alternative asset allocation, with insights on late-cycle investing
A new baker quickly learns the need for precision and discipline. A third of a cup of flour is quite different from half a cup, after all. So too must investors learn the need for discipline in alternative asset portfolio construction. Investors are increasingly looking beyond traditional asset classes to achieve their objectives, recognizing that a sizable allocation to alternatives can be additive to their portfolios. However, too often investors assemble a collection of alternative assets in a one-off manner, not giving enough thought to how the allocations will work together in a portfolio.
As public markets face growing challenges, we believe that a strong alternatives framework—a precise recipe—is essential to building resilient portfolios. Alternative asset portfolio construction should be holistic, comprising three basic components: a core foundation, with assets such as core real assets and core private credit designed to provide stable income with lower volatility; core complements, with assets such as hedge funds adding diversification through differentiated returns; and return enhancers, with assets such as distressed credit and private equity seeking opportunistic returns.
Investors should right-size both the mix of alternatives and the risk within each asset class to ensure that alternatives serve their intended role in an overall portfolio. An allocation of 20% to a diversified alternatives portfolio can increase return and reduce risk (EXHIBIT 1). Approaches vary. But we believe that (in the absence of constraints) within an alternatives portfolio a balanced allocation of 70% to the core foundation and core complements and 30% to return enhancers offers investors strong prospects for sustainable long-term success.
A right-sizing approach may be especially helpful in today’s late-cycle environment, when investors need solutions that will both help insulate them from more challenging market conditions and provide the potential for enhanced returns. All three components of a diversified alternatives portfolio, described below, have a role to play in late cycle:
Core foundation to provide stable income
In essential assets such as core real estate, infrastructure and transportation, investors can find stable income streams and local uncorrelated returns that can, in most cases, grow with inflation. The income from core is designed to be stable and predictable for many years, meaning it also serves as a volatility cushion. We believe that a tilt toward strategies where a majority of return comes from income and growth of income rather than from multiple expansion (i.e., core and core-plus real assets) can help make portfolios more resilient in late cycle. High quality, covenant-tight private credit can also serve as a reliable income provider. An overweight to core—conservative alternative investments that typically use little to no leverage—is particularly desirable in late cycle, as the risk of refinancing leverage adds significant beta to highly levered strategies.
An allocation of 20% to a diversified alternatives portfolio can increase return and reduce risk
EXHIBIT 1: RISK AND RETURN PROFILES FOR A 60/40 GLOBAL EQUITY-BOND PORTFOLIO AND A GLOBAL CORE-PLUS 20% ALTS PORTFOLIO
Source: J.P. Morgan Asset Management Alternatives Solutions Group.
Notes: (1) The global core-plus alts portfolio contains the following categories: global core real estate, global core infrastructure, global core transport, core private credit, hedge funds, liquid alts and private equity. (2) Illustrative long-term analysis uses asset class data from 1998 to 2017. (3) The target returns are net returns for illustrative purposes only and are subject to significant limitations. An investor should not expect to achieve actual returns similar to the target returns shown above. Because of the inherent limitations of the target returns, potential investors should not rely on them when making a decision on whether or not to invest in the strategy. Please see the complete Target Return disclosure below for more information on the risks and limitation of target returns. (4) Return per unit of risk is calculated by dividing the 20-year CAGR by the 20-year standard deviation. (5) Volatility is calculated using historical annual 1998-2017 standard deviation of historical returns. (6) Equity beta is computed relative to the MSCI World benchmark. (7) The inflation sensitivity is calculated using the U.S CPI Index + 3% on a rolling three-year basis. (8) The portfolios assume annual rebalancing. Past performance is not indicative of future results. Diversification does not guarantee investment returns and does not eliminate the risk of loss. J.P. Morgan seeks to achieve the stated objectives, but there can be no guarantee the objectives will be met.
Core complements to benefit from increased volatility
Hedge funds are flexible structures, allowing many managers to take advantage of the increase in dispersion and dislocation that accompanies both normalizing levels of volatility and rising rates. Relative value strategies in particular stand to gain, given their ability to deliver uncorrelated returns and to benefit from a more uncertain environment. Across hedge fund strategies, rigorous manager selection is critical to identify investments that can be additive throughout market cycles.
Return enhancers to take advantage of corporate stress
Special situations and distressed debt strategies will be positioned to benefit should defaults tick up following multiple years of increased credit issuance and looser credit standards. Private equity continues to be another potential source of enhanced return, but, as with hedge funds, it demands a greater focus on manager selection. In late cycle, we note, investors should focus on managers that can offer operational improvements to the companies they own and rely less on financial engineering to generate returns.
PORTFOLIO CONSTRUCTION AND THE BENEFITS OF PRIVATE INVESTMENTS
A portfolio construction framework allocating 70% to the core foundation and core complements is also a framework for liquidity management: Non-core return enhancers are by definition less liquid and more vulnerable to market timing. In short, disciplined alternative asset portfolio construction is also disciplined liquidity management.
Post-financial crisis, many investors learned the importance of matching underlying investment duration with a fund’s liquidity terms. Additionally, investors are realizing that they should look at both return enhancement and total risk reduction to evaluate the benefits of the full spectrum of illiquidity available in alternative investments.
Particularly in private alternatives, investors also benefit from an information advantage and control premium vs. traditional assets. For example, in private equity and infrastructure, control of a company or asset allows for an increased ability to impact financial and non-financial (e.g., ESG—environmental, social and governance) factors. With an alternatives platform encompassing over USD 100 billion in ESG-integrated assets under management, and a commitment to partnering with communities and investors, we’ve seen firsthand how the consideration of ESG factors can help reduce risk and ensure the sustainability of returns.
In any stage of the economic cycle, discipline is essential in portfolio construction, but positioning and strategies must evolve as markets shift. As alternative asset allocations increase, investors must move from a best-ideas mindset to an application of greater discipline—more science, less art—in their allocation decisions. Returning to our baking analogy, while baking is a science that always demands discipline, seasonal choices will vary (blueberry pie in the summer, pecan pie in the fall). Especially in today’s late cycle—when liquidity becomes more precious, income becomes scarce, risk and correlations are a growing concern, and information and control can make an even greater difference—alternative asset investors will benefit from a strong framework. That framework will offer a clear view into opportunities and risks to deliver diversifying and resilient investment outcomes.