David Lebovitz: Welcome to the Center for Investment Excellence, a production of JPMorgan Asset Management. The Center for Investment Excellence is an audio podcast that provides educational insights across asset classes and investment themes. Today's episode is on using alternatives for income and has been recorded for institutional and professional investors. I'm David Lebovitz, Global Market Strategist and host of the Center for Investment Excellence. With me today is Anton Pil, Global Head of Alternatives. Hi, Anton. Welcome to the Center for Investment Excellence.

Anton Pil: Hey, David. It’s great to be here.

David Lebovitz: So, today, we're excited to be discussing a topic which is really imperative for institutional investors to consider in implementing portfolios, which is the idea of using alternatives for both diversification and income. Anton and I will shed some light on a number of different factors to keep in mind from everything, starting with which asset classes provide the most income, to how alternative asset classes fared during the pandemic. And then finally, a few thoughts around the management of liquidity and the trade-offs between the various asset classes that generate income within the context of alternatives more broadly. 

So, with that said, let's jump right in. I think it's a really interesting time to be having this conversation around the role that alternatives can play, both as it pertains to income and diversification. Rates have obviously taken a pretty significant move lower here over the past couple of months, and they're still very, very low in absolute terms. 

When we look forward, it seems like the Fed is going to move slowly, absent a spike in inflation. And so, we have this environment where rates are on the low end of their recent range. The Fed is clearly not in a rush as they move to the exit, and clients are increasingly reaching for yield in fixed income. 

A lot of the clients that I speak to, they're going down in credit quality within things like high yield and leverage loans, and that's a bit of a cause for concern, particularly given the fact that most of the stimulus that we expected, is now in the rearview mirror. 

But despite some of these challenges within traditional markets, and namely fixed income, we do see opportunity in alternatives. And we think that that opportunity may be somewhat underappreciated despite the ability of these assets to deliver uncorrelated streams of income. 

And so, Anton, would love to get some of your thoughts around why core alternatives make sense when the goal is income, and which asset classes in particular clients can be using to achieve both of those portfolio goals.

Anton Pil: It’s a fascinating time. I've been with the firm here for over 25 years, and I don't remember rates being anywhere close to where they are today. And one of the tipping points to me was when you all of a sudden saw the high yield, not only spread levels hit all-time tights, but the absolute level hit all-time tights. 

And now, sitting in the alternatives world, I look around and I don't see most of my sort of sub-asset classes within alternatives, anywhere close to the highest levels they've ever traded at. And to me, it's pretty simple why. The Fed, as well as other central banks around the world, are pretty much buying every asset they can get their hands on. 

Now, they're not buying private assets. So, they haven't started buying offices. They're not buying buildings. They're not buying infrastructure. I mean, maybe one day they will, but they haven't yet. But they are buying all these liquid assets. So, to a certain degree, you've got a buyer out there who's got an unlimited appetite who valuation is somewhat theoretical. 

It's not like a Fed comes in and says, you know what? I think at 132, this is too expensive. Let's wait till it's at 138. No, they’re just buying. They’ve got the money. They've got to keep spending. And so, you're seeing this disconnect between private and public markets, and that's actually resulting in some pretty interesting opportunities for people who can understand and live with illiquidity of a private market versus a public market. 

So, I think that's been a pretty sizable evolution that the clients who have the ability to own these privates are taking advantage of in bigger and bigger size. And it's fascinating. The risk appetite has also shifted, I would say five to 10 years ago, the majority of clients want to use alternatives to boost up their returns. They actually wanted to outperform a broader balanced portfolio. 

Today, I'd say a lot of the demand we're getting is really as a fixed income proxy. I need something with a lower correlation to risk assets and ideally public equities, and gives me some degree of income to replace fixed income. And that's a fairly new phenomenon in the last call it two, three years, really accelerated in Europe when rates hit zero in Europe, but now really taking off in the United States as well. And I think that trend is here to stay.

David Lebovitz: Yes, certainly something that we've seen our clients doing, allocating away from fixed income and into things like core real assets in particular. I know that that's been a big focus for us at JPMorgan over the course of the past couple of years as you noted. 

But when you think about what the Fed has been doing in terms of focusing on public markets, I think that's a really key piece of the puzzle. And there's also the idea that public investments are getting mark-to-market every day, which certainly isn’t the case for the private side of the equation. 

And so, as we see investors, particularly institutional investors, embrace these less liquid assets for both income and diversification, it's important to set reasonable expectations in terms of their performance going forward. And so, I’d love to get a little bit of your take on, one, how these less liquid assets fared during the pandemic, but two, kind of the outlook for the way things like real estate and infrastructure and private credit may perform here going forward.

Anton Pil: Yes. Look, it's fascinating because to some degree, illiquidity can be your friend, because if you just wake up every day and you look at your mark-to-market, you might get swayed by your mark-to-market, irrespective of the fundamentals. And we saw quite a bit of that in real estate during the early stages of COVID where we were getting rental income that was in many cases 99.5% of previous rental incomes well through most of the period of COVID, yet valuations and public market imply that real estate collections were probably half of what they were pre-COVID levels. 

And we saw no evidence of that at all. If anything, we actually saw a continued growth in our rental incomes across many of our assets. So, I think the public markets are trying to sort of read through the tea leaves preemptively, and in this case, frankly, got it wrong. 

And so, to some degree, if you had too much liquidity and you could get out, you might have actually made a decision that you would regret later on. So, I think illiquidity is not always necessarily a negative. It can actually be a pretty big positive in terms of forcing you to hold off assets longer over periods of time. 

Where that's going to be particularly important, I think, is in people's fear around inflation. We haven't seen inflation in decades, right, in the United States, and we have it in spades right now. Now, we can debate, is it temporary, not temporary? I keep trying to get economists to tell me what temporary means. And as far as I'm concerned, temporary is the term that's used until the day it’s no longer temporary. 

And I don't know what that is. That could be six months. Some people say it's three months. Some people claim it's a year. But one of the things that I think real assets in general, whether it's real estate or infrastructure, can help you with is, you own an asset that's generating an income, but the asset itself doesn't have a prescribed value. 

In a bond, I'm going to get back the $100 I gave you. For a $100 phase, I'm going to get back 100. That is not the case in a real asset. I'm going to get back the value of that asset. And assuming inflation is kind of fairly spread out across the board, I'm going to get an asset back that's worth more than the $100 I put in that's kept up with inflation. 

So, I think the value of that option, I wouldn't underestimate the value of that because a lot of assets today don't have that sort of embedded inflation protection that I think real assets do have. I think in terms of the stability of income, I think the stability of income across most of these assets is very high, especially in places like infrastructure, where in many cases we have contracts that run 20, 30 years. 

We have windmills that spin. The people who are buying the power off those windmills, have a 20-year contract with us, obliging them to buy that power for the next 20 years. Similar with transportation assets, and as long as we do a good job choosing our counterparts, those incomes can be remarkably sticky and stable, and they have the side benefit that in many cases, they have natural increases built in. 

Most of our real estate contracts have rental increases of 2 to 3% guaranteed every year. So, that's quite different than fixed income, where if I have a bond, you're going to earn 3%. That's what you're going to get. You're going to get $3 on the $100 you gave me. You're going to give me $3 every year. 

That's not true in most of our real assets because they've got built-in increases every year. Your $3 next year will be $3.06. So, it actually rises every year. And in the infrastructure case, many times that rise is actually calculated directly as a function of inflation, because many municipalities who help us set the value of those incomes, need a benchmark. And what's the simplest benchmark to use? Inflation.

So, you'll end up with sort of a double benefit associated with many of these assets. And look, I think as long as we need housing, as long as we want to order packages delivered to our homes, as long as we're going to use power, as long as we need water and a sewer system, the stability of this income is extremely high. And I'm not particularly concerned about the volatility of those income streams over time.

David Lebovitz: And I think you make a couple of really good points. One was the ability for, particularly on the infrastructure side, those income streams to remain relatively stable during the pandemic. And to me, it was kind of an acid test for infrastructure, because it’s a newer asset class here in the United States, despite being a bit more incumbent over in Europe. 

And again, I think that that hopefully will give investors increasingly more confidence to put money to work in these asset classes going forward. And, you know, the inflation one, I appreciate that you poked fun at my profession a little, because, you know, that's why economists have two hands, right, on the one hand, this, and on the other hand, that.

The inflation issue is real. And we do believe that we are not embarking on a 1970s type of inflation, but we do think it could be stickier to longer than particularly the Federal Reserve currently is expecting. And I was having a really interesting conversation a couple of weeks ago with somebody where, we were basically talking about the tails of the inflation distribution. 

And so, you either, on the one hand, end up in this environment where inflation is more persistent and arguably is a little bit more problematic than people expect. The other tail is that you end up in a world where, well, it looks a lot like the post-financial crisis world, a series of twos, 2% growth, 2% inflation, very low rates. 

And I think what's interesting is that in both of those environments, things like real assets can play a role. To your point, in a higher inflation environment, you get some of that protection which is baked into the cash flow generation of the asset. In a very low rate environment, low growth environment, now we go back to having the same conversation that we've been having for a decade.

And so, I certainly don't believe in silver bullets, but I do think that there's a use case for these investments, regardless of which side of the inflation distribution you're sitting on, but …

Anton Pil: One other quick thing.

David Lebovitz: Please. 

Anton Pil: I think people are also beginning to do the absolute return math on TIPS, right? So people say, well, I own TIPS. I own inflation-protected securities, but that's correct. That inflation-protected security will outperform a nominal security, but it doesn't mean it's actually going to have a positive return at all. It could still have just a less negative return in an environment where inflation expectations surprise on the upside. 

So, the need for sort of a diversified pool of hedges around inflation is definitely coming up. And then secondly, the other thing you mentioned, which I agree with, part of the other reason people are owning these assets, is to allow them to keep holding on to some of their riskier assets for longer. 

If you take public equities, the easiest thing would be to tell people, look, who would have thought that the equity markets were going to be up 15 to 20%, depending on where you are in the world so far this year in the midst of COVID and a rebound, et cetera. And in some cases, the rebounds have been absolutely incredible. 

So, if you're riding that wave, you have a choice to sell and monetize, but where do you go? So, if by owning some of these assets that give you an uncorrelated return to equities, and it allows you to hold on to those equities longer, most people would like to do that. 

And so, it allows them to postpone the decision-making process on when to take money off the table in equities. We're seeing quite a bit of that. So, that's the diversification angle. It's not so much the volatility of the portfolio. It allows them to just hold on to their equity risk longer than I think they'd otherwise probably would.

David Lebovitz: Right, which as we started by discussing, given the current level of interest rates, is increasingly an important thing to be able to accomplish within the context of a long-term diversified portfolio. But, you know, one of the things that we hear from clients when we have the conversation around alternatives broadly, and core real assets in particular, is about the issue of liquidity.

By my lights, liquidity budgets are kind of like leverage. It's much more about how you use them, rather than the absolute level or size. And so, I'd love to hear from you the way that you think about managing those trade-offs, the way you think about managing liquidity alongside both income and diversification, because I think illiquidity is keeping a lot of people on the sidelines. 

And one of the things that we touch on in our upcoming paper as part of our long-term capital market assumptions process, is that access is improving and the ability to have semi-liquid alternative investments is improving as well. And so, would love to get your take on kind of the general state of liquidity and the way you think about it within the context of a portfolio.

Anton Pil: Yes. Look, I think probably one of the best uses of time for an investment manager, or for anyone who's managing a series of assets, is to figure out, how much money do you really need urgently at any point in time? And the sooner you can calculate that, the more illiquidity you can take on in your portfolio. 

And it's fascinating. I've had people tell me, I need to have access to 30% of my portfolio at any point in time to be able to move it around. And then you ask them, like what's the biggest move you've ever done? And it's 4%. So, you kind of look at that and you go, when would you ever move 30? And they’re like, well, you know, maybe one day the investment committee comes in and we want to move all to equity and we don't want to move to equity. 

It is an extraordinarily important analysis, and I think it has to be driven by your liabilities. It has to be driven by, what is it that you believe you're going to have to pay out on an annualized basis? And that, just like when you think about people taking out a mortgage or taking out a loan or when we buy an asset that we leverage, we have to think about sort of that liability matching. That should be the basis for your liquidity criteria. 

And if anything, I would argue the liquidity in private markets in general continues to get better. So, private markets are probably now surpassing public markets in terms of their magnitude, so depending on how you calculate that. And what that's resulted in is a much bigger secondary marketplace for private positions, for the people who are trying to move around actively amongst their private positions. 

But the reality is, especially in today's environment where we've had huge run-ups in fixed income markets, equity markets, a lot of plans are much closer to fully funded than they've been in the past, and can probably absorb much larger amounts of illiquidity than they have in the past. 

And I would argue, in credit space, you'll pick up generally about 100 basis points to 150 basis points, or 1 and 1.5% being less liquid than your public counterparts. And I think in equities, I would argue that number is anywhere from, depending on kind of how you think about, 2 to 4%. 

And those are material numbers, especially when you consider that the long-term capital market assumptions on a lot of these returns, are probably half of what they used to be even a decade ago. So, those sort of return profiles you can get for that illiquidity, I think are absolutely key. 

And they're becoming key for everyone, not just institutions, but also for individual clients. And giving more and more individual clients access and comfort with that illiquidity, I think is where the world is headed in the next five to 10 years.

David Lebovitz: You're certainly seeing it in real-time in terms of product development. And I think that your framework for thinking about liquidity within the context of your liabilities, is a very interesting one, because given the higher yields that are available on some of these asset classes, right, when you think about it in that context, going less liquid can actually work in your favor if your end goal is matching those liability payments down the road. 

And so, we’ve covered a lot today, and this has been a great conversation. I want to bring it to a close with just one more question. And we see more and more clients are becoming first-time users of private alternatives. Other clients have been investing in things like real estate for decades. 

And so, as the private investment universe grows in size, as well as the share of portfolios, I think investors are going to be increasingly asking about what comes next. And so, for those institutions who have a dedicated allocation to core alternatives and are thinking about enhancing their alternatives program, where do you see some opportunities going forward, whether it be in real estate, private equity, credit? Would love your thoughts on where things are headed from here.

Anton Pil: Yes. Look, as alternative allocations just in general amongst institutions has increased, we've seen increased specialization of those allocations. I've seen some large institutional European clients where those allocations are now 60%. And that 60% is just like if you think of your equity allocation as broken out between core, core plus, opportunistic, across private equity, private credit, real estate, infrastructure, et cetera. 

And then within those sub-segments, they actually will take on different risk profiles. It's been a remarkable evolution, but there's definitely been a continued trend towards more opportunistic risk-taking and more thematic investing. And that could be anywhere from in the real estate or infrastructure space on more sectoral investing, as people have gotten more comfortable with their allocations and their allocations have gotten bigger. 

Many people have also bulked up their investment teams in these areas. And so, those investment teams are making those sort of subsector decisions, and we're seeing that happen real-time. And I think that the days of the blind pool, give me $50 billion and I'll just spend it for you and you'll be fine, I think the next five to 10 years, I think those days are over. 

I think many of you are going to be demanding much more transparency and knowledge in advance of allocating monies and where those monies are going to go. You deserve to demand that. And I think as an investor, you should be asking, are you going to be investing this, in which region of the world, which segment that it’s going to do? 

And I think those evolutions in private markets, we saw those probably two or three decades ago, and public markets are coming to private markets. And we're seeing that real-time today. People are becoming fairly prescriptive about what they're looking for in private markets, as they actually have that choice as the markets have gotten bigger. 

And I think that's a longer-term trend, whether it's around ESG, biopharma, impact investing, renewables, et cetera. I think those trends will continue. And by the way, we'll see that also in real assets as well, and I think we'll see that in private credit.

David Lebovitz: Well, certainly, a lot to keep our eye on here. And I think we're out of time for today. So, we'll have to have you back to talk about how all that plays out here going forward. But Anton, thank you again for joining us, and we look forward to having you back on The Center for Investment Excellence sometimes soon.

Anton Pil: I appreciate it, David. Thanks for taking the time.

David Lebovitz: Thank you for joining us today on JPMorgan's Center for Investment Excellence. If you found our insights useful, you can find more episodes anywhere you listen to podcasts and on our Web site. Thank you. Recorded on August 3, 2021.

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