Coordinator: 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.

Keith Cahill: Welcome, everyone. Thank you for taking the time to join us today. My name is Keith Cahill and I lead the North America institutional client business here at JPMorgan Asset Management. Today, I'm excited to be joined by two of my colleagues. 

First, Jared Gross, who is head of institutional portfolio strategy in our institutional North America business, as well as Pulkit Sharma, head of alternative investments, strategy, and solutions. Gentlemen, thank you both for joining me and our audience today.

Jared Gross: Thank you, Keith. It's a pleasure to be here to be here. 

Pulkit Sharma: Nice to be here.

Keith Cahill: Wonderful. So, over the next hour, we'll touch on key takeaways from Jared and Pulkit’s recent paper on the benefits of pivoting to income in institutional portfolios. As a reminder, this is the second theme in a four part series of research articles authored by Jared in partnership with investors across the firm.

The first theme was released last month and focused on diversification among the traditional hedging strategies and allocations. The entire series can be accessed at jpmorgan.com/perspectives. So with that, Jared and Pulkit, let's get into it. 

Jared, I'll start with you. The theme of the paper is called Making Income and Objective. Talk to us about the theme, why was it included in this research series, and what should institutional investors be thinking about when it comes to yield, diversification, and total return? 

Jared Gross: Thank you, Keith. It's a pleasure to be here and to have a chance to talk with everyone today about this paper and the broader series. 

As you mentioned, this is the second paper the first one dealt with portfolio diversification specifically as it relates to hedging strategies and following this paper, there will be additional work done on the topics of (liquidity) and capital efficiency. But today, we're focused on income and specifically this idea of making income an objective.

To begin, I just want to draw kind of a high level overview around you know, the commonalities that all institutional investors share. They seek diversified sources of return, looking to manage risks effectively and efficiently, look to preserve operational flexibility and ultimately to meet institutional objectives. Frequently, these include paying benefits, delivering institutional support for facilitating additional opportunistic investment and rebalancing across time.

The challenges that we face today are interesting in that we are in an environment where we expect forward looking returns on traditional asset classes to be relatively low. We observe fairly high valuations in the equity market, which tends to indicate lower returns going forward. We observe low yields in the bond market, particularly in the Treasury market, which tends to indicate lower returns on fixed income over a medium and longer term horizon. 

And alongside this low return environment, the risk management techniques that we have evolved to help build and manage risk at the portfolio level are increasingly stressed. We have less confidence in traditional relationships across asset classes and the cushioning effect of income from traditional fixed income strategies will be lower given the level of yield that we see today. 

So, against this backdrop we want to recognize those objectives that all the investors (care) but consider tweaks or adjustments to the portfolio strategy that will improve their ability to make good on those objectives and generate better outcomes in this challenging environment. 

And one of the things that we are very focused on is tilting portfolios away from assets that are dependent on generating returns from higher valuations, which by necessity require either additional decline in interest rates, or some other exogamous events to drive returns higher, and focusing instead on assets that can deliver return organically through the production and delivery of income and then require less in the way of changing valuation going phones. 

And you know, we think of these to some extent as hybrid strategies that seek a higher level of yields that you deliver a lower level of equity data, and frequently come at the modest risk of additional illiquidity. So, we really think there are some opportunities out there to introduce you the portfolio construction process and as we say in the paper, ultimately, this will lead to a greater degree of resiliency in a challenging market environment. 

Keith Cahill: I think that's a great intro to the paper and the content that we'll be discussing here today. Pulkit, maybe I'll turn it over to you. Given your expertise and responsibility in the alt space, can you spend a few minutes specifically on the alt space and its ability to generate durable and uncorrelated income, and then maybe touch on how alternative asset classes have performed through the pandemic.

Pulkit Sharma: Great, thanks, Keith. So, I think of alternatives and income really solved for two major outcomes. One is providing a higher level of income and doing that, with diversification. And in the backdrop, Jared talked about with all the policy intervention, this notion of a risk free rate itself is challenging in that there is rate of return left in that definition. 

In this backdrop, when we just define what we mean by income producing alternatives and I'll lay out a framework for thinking about relative value between various public and private markets, and then the impact of the pandemic on some of these strategies. So from a definitional perspective, what does income producing alternatives look like especially in the higher quality in this spectrum?

They look like today on a relative value standpoint, logistics asset or multifamily asset in the dominant market, in the developed markets with a long term lease, do they look like a solar farm or a wind farm or water utility, which has contractual cash flows from strong counterparties, they look like moving Infrastructure transportation assets of an (energy) carrier with a 10 year lease against the strong counterparty. 

On the credit side, they look like senior loans or first lien loans to resilient sectors of the economy. They look like hybrid structures such as mezzanine debt, higher quality preferreds. All of these asset pools have a few things in common in that the returns of these assets are underpinned by contractual cash flows from strong counterparties.

Roughly 75% plus of the total return for these categories come from visible for castable income. They are underpinned by essential assets or higher quality points in the capital structure. They are usually access to a more systematic, rather than idiosyncratic approach, and they have moderate amounts of leverage. So, that is what binds the core alternatives or income producing alternatives segment.

Now, putting in a relative construct in an income diversification framework, where diversification is really versus equity risk, which is usually the predominant risk in most plan sponsor portfolios, investors can get yield today, in segments such as high yield, or income producing equities REITs. The cost of that yield really is diversification of first equity risk. That's one way of sourcing income that has a tradeoff. 

The other segment, which is a traditional source of fixed income, which is core fixed income is a little bit more challenged with the low starting points on yield, and very low real yields. But it also has the role of diversification versus equities, but the opportunity cost is higher today than it has been in the past.

And the world of alternatives really sits in a place where it provides higher income two to three times that of school bonds today, and with half the volatility of equities when done in a diversified construct, but the cost of that high income low beta is really liquidity. So this is how income related categories stack up versus the public market. 

Now in terms of what's happened in the pandemic, a few things have happened, especially in the public markets, cash rates have gone down, the returns on bonds have compressed, the risk premium on equities has compressed, but not a lot has changed in the income producing higher quality core alternative space. 

So, if you're a real assets investor, you are looking at an asset pool with a numerator which has a 5% to 10% impact from rent collections on the income side and a 5% to 10% capital value correction. On balance or initial yields are flat. What that means is while other asset pools have compressed, the relative risk premium or relative value for some of these categories look stronger. 

So, what are these categories producing? They are producing a one of the most scarce outcomes which is income and diversification in combination. They typically look significantly mispriced versus other risk assets and particularly higher quality treasuries or bonds. They're also scalable. 

So, in terms of when we talk about talking about income as an objective, they are really an essential component as investors look to achieve significantly more resilient returns. In the future, these categories will play a more essential role, not an optional role going forward given their descent in the capital markets.

Keith Cahill: Thanks Pulkit. That's fantastic. And again, really good insight into how you guys structured the paper and the work. Maybe to go a little bit deeper here and this is for both of you. It's kind of a two part question.

First, you both have insight and input into our long term capital market return assumptions. Without getting ahead of their finalization and release in the next few weeks, can you share your insight into what institutions should expect out of traditional allocation and risk frameworks like a 60/40 portfolio. 

And then second, in the paper, you talked about the difficulty of this environment on traditional portfolio optimization tools and models. Can you talk about the impact of that reality on portfolio construction and asset allocation for institutions?

Pulkit Sharma: Maybe I'll start. If you talk about the traditional portfolio, the 60/40, the notion of that has already passed its relevance in over the last two, three decades. In fact, most institutions don't have a 60/40 portfolio they already have embraced private markets to the extent of 20% already. 

But if you look at the stock bond frontier 10 years to 15 years ago, that generated a 7% to 8% type of returns, let's say in sort of 2008 timeframe. Fast forward to today with all the policy intervention in place, if you look at the last year’s (ITCMAs), the stock, one frontier was trending more towards a five on a 60/40 type of a portfolio. And you can guess where that number is moving this coming year, when we release the next version of the (ITCMAs). 

In the light of this shrinking returns, in sort of the higher quality additional assets, I’ll give an example of core real assets, income producing segment of hard assets, they sort of sit at a 6% to 8% mark, but 75% of that return comes from income. So, they are really above that capital market line or the efficiency line.

And one thing we talk about in the paper is that in today's market environment, it's all about the starting point. So, the starting point of returns is very low, four points, sort of challenges forward returns, at least in the near term before cash rates normalize. And at the same time, the risk premium for equities has come down, so the valuations are higher and that challenges the prospective returns for that too in the near terms.

However, when we look at the risk premium for income producing assets in the private market, especially the core end of the spectrum, and look at 40 years of data, I’ll quote real estate data here, when you look at the spreads of income versus triple B bonds as stocks, have a risk premium relative value, the level of spreads we see today, and you can add incrementally around 2% and a little bit more for categories, which are infrastructure, transportation, or high quality into the credit at those levels of spreads, we’re forward looking against has really ranged between 5% to 15% for real estate over the next five years.

And this is all because the risk premium hasn't really compressed in this higher quality private market pool, the compressed level of income is a tailwind and also leverage seems to be more accretive today, given the low rates.

Jared Gross: Keith, you also raised the topic of portfolio optimization and the tools and models that go into that process. And I just want to spend a moment sharing some thoughts on why those are challenged in this environment. You know, as Pulkit noted, not just have the levels of expected returns come down broadly across asset classes, but the range in which the expected returns now exists, has become compressed.

And you're making judgments across asset classes based on relatively small and subtle differences in forward looking expected returns. The margin for error around that process has decreased and so, we have to be very careful about relying with too much confidence on those assumptions. 

You think about a classic mean variance optimization model, the inputs will typically be an expected return of volatility and then a series of cross asset class correlations. As mentioned, the fact that a range and levels of returns have become compressed. Unfortunately, we can't say the same for volatility. Volatility in the market remains elevated and is likely to remain elevated for some period of time. 

Now, you can take some comfort from the Feds intervention, and maybe that has put a brake on some of the left tail outcomes that we might fear. But even since March, there's been a lot of volatility in the market, so, we’re certain we can't assume that way. And similarly, correlation assumptions are subject to greater uncertainty, the most important of which is the assumption of a low or negative correlation between equities and fixed income. 

And, you know, again, in part due to the Feds intervention, that relationship has broken down a little bit and we are looking at a world where the Fed is actively trying to induce inflation. And if we dial back the historical clock and look for environments where stock bond correlations were not negative, but were in fact more positive, inflationary environments do tend to exhibit that type of correlation, reversal, and behavior. 

So, we have to be a little bit careful about a lot of the underlying assumptions that we've relied on. It's also probably worth noting that at least for fixed income, the distribution of outcomes is not likely to be symmetric going forward. I think the Fed has insulated the markets pushing rates down to very low levels such that while it may take a while for rates to rise, it certainly appears far more likely that they will rise over a longer horizon than fall. 

And we have to consider that as we contemplate the current level of fixed income holdings, and the duration of those holdings, but more broadly, the sensitivity of the overall portfolio to interest rate risk. There is a concept of effective duration that exists, which is applied not just to fixed income assets, where duration is widely understood and very quantifiable, but to a broader range of asset classes, looking at their current movements over time with changes in interest rates.

And one can make a, perhaps somewhat naive assumption but probably accurate, that as falling interest rates have been a source of support to risk markets over the last several months and even years, a reversal of that trend would likely lead to a negative effect or a headwind on returns, so we are concerned about these things. 

One of the responses and this gets to focus earlier comments is to move a little bit away from the barbell style portfolio that we have relied on which, broadly speaking, emphasizes equity risk in the return seeking portfolio and uncorrelated fixed income, low volatility assets as the hedge. 

I think if the thesis that we are putting forth is accurate, that there's an opportunity to move to a more efficient portfolio that embraces hybrid strategies that sort of meet in the middle that has some equity like characteristics, some debt like characteristics, but generally exhibit higher yield and lower equity beta with some illiquidity. 

A larger allocation to that type of strategy will allow for smaller exposures out in the wings on both sides, potentially a little bit less equity. And as a result of owning less equity, less need to hedge that volatility with a conservative and at this point, very low yield in the fixed income portfolio.

Keith Cahill: So, I think the case makes a lot of sense there, right. And the challenge becomes fixed income served a very useful purpose because of all of its features, traditional fixed income. As we look for alternative sources, because of the challenges traditional fixed income faces, there's got to be tradeoffs that investors need to think about. 

So, maybe I'll start with Pulkit. Can you talk about some of the tradeoffs that investors have to grapple with as a pivot to income as you put it?

Pulkit Sharma: Sure. So, the benefits of income and diversification, especially even at the higher end, higher quality in the alternative spectrum come with tradeoffs and that's, I would say there are three main tradeoffs to be aware of, and there is a whole income play in each of these tradeoffs, which I'll highlight. 

The first one is illiquidity. Private market alternatives, even at the highest quality in this spectrum are not daily traded. They are not daily liquid. However, there is a spectrum of illiquidity. It's not a binary construct. So, on one end of the spectrum is private equity, which is, let's say, the most illiquid but also the most return enhancing of alternatives.

And on the left end are the more (conservative) end of the spectrum are income producing alternatives with 75% plus of total return is from income. These categories of alternatives, again, have these contractual cash flows, which by themselves are a source of liquidity and they tend to be relatively more liquid, typically access to perpetual life strategies, which have a spectrum of liquidity associated with them, and they can be used for benefit payments. For example, the cash flows which these strategies generate and really talk about relative value, which these categories have today. So the key point that is illiquidity is non-binary are relatively more liquid and relatively less liquid strategies and that's how we evaluate alternatives on that spectrum. 

And that sort of also speaks to the fact that the traditional (unintelligible) doesn't really work in the private markets, because some of these tradeoffs. The other tradeoffs is manager dispersion, which also has a spectrum. So, if you have in three-fourths or more of your total return coming from forecastable stable income, by definition, the dispersion of outcomes are going to be lower and this is exactly what we have seen in (medical) evidence. 

So, the higher the proportion of return coming from capital appreciation or actual return, the more will be the manager dispersion of return on a relative basis. So, category for this private equity or hedge funds (unintelligible) to have higher dispersion. In the real estate space, we have a lot of datal. We find five times more dispersion in the opportunistic space versus the core space. So there's a wide spectrum, income buffers, manager dispersion and illiquidity. The current tradeoff is the tradeoff of volatility (in) down cycles which are embedded in alternatives as well. And while managing dispersion still in the income producing alternative space, one of the key attributes for all income alternatives is that they tend to be non-correlated to each other. 

So, think of a cash flowing logistics asset or a cash flowing utility or a cash flowing contractual, maritime asset, or think of senior secured loans, all of them tend to have very different economic drivers of returns. So, with income alternatives, investors have a pretty unique ability to build what I would call a global portfolio of local uncorrelated assets, which what it does really is dampen the tail risk, the downside volatility, standard deviation of returns. 

And that's really the power of looking at alternatives or looking at even public and private markets and accessing the widest swath of income producing strategies. Because they do sort of similar things from a diversification income standpoint, but they tend to be non-correlated to each other and that's a real opportunity in terms of looking at income as a goal and objectives because the opportunity cost today of not doing that is the highest it's ever been. 

Keith Cahill: Interesting. Okay, so I want to go back to your first point on illiquidity and maybe I'll give it to Jared here. So Jared, as you look towards your next theme on illiquidity, which would be the next piece that you referenced, can you talk to us about the liquidity concerns many institutional investors have, particularly those that are underfunded or cashflow negative, talk about the role of income producing strategies, even illiquid ones and helping alleviate those liquidity challenges that institutions face.

Jared Gross: Yeah, thanks, Keith. I think this is a really interesting topic to dig into and obviously, this will be the subject of the next paper where we can spend more time on it.

But the approach to illiquid assets for a lot of institutional investors and the approach to portfolio liquidity overall, has been maybe a little bit ineffective or inefficient over the years. And what I mean by that is, we have looked at the more illiquid, extreme end of the spectrum, private equity funds, private real estate funds, you know, there's a variety of investment vehicles out there that have J curves, and long locks and fairly delayed return of capital.

So, if you think about it on sort of an average life basis, they are quite distant in terms of when you get your money back relative to when you allocate the capital. And so, with that as the model for illiquid investing, there has been a preference for highly liquid strategies elsewhere in the portfolio.

And so you see a preponderance of either daily liquidity vehicles like funds or separate accounts that have essentially the ability to be drawn on demand. And there's a spectrum of illiquidity that exists in between that has been somewhat under exploited.

And so, I would say at a high level, one of the appeals of using income generating alternatives is that if our concern about illiquidity is that in the near term, it diminishes our ability to source capital from the assets and deploy it for other ongoing purposes. 

Income generating alternatives, at least to some extent, offer a cure to that problem, which is that the income itself provides the plan the resources to pay benefits to engage in institutional support or invest opportunistically where money that is locked away for you know, 7 to 10 years would not.

And then, I also would just observe that in recent years, I think there has been a much better evolution of the alignment between the structures that are offered in the alternative investment space and the underlying opportunities. 

And so, there is a range of liquidity from again daily liquidity on one end up through separate accounts, hedge fund strategies, which have on the surface fairly attractive liquidity terms, but obviously have the potential to gate liquid alternatives which frequently have a 12 month 18 months initial lock and then liquidity thereafter or interval funds and then you get into the private credit space where it may be a two or three year initial lock. 

But the broader point is that there is a wide spectrum of liquidity vehicles that investors can select from and you know, some of them are income generating some of them are not. The fact that some of them are not income generating does not in and of itself, make them poor investments, they very well may be terrific investments.

But in this environment where liquid market returns are likely to be low, and the expectation of further capital appreciation either in fixed income or equities is somewhat diminished, income does have that special ability to support those operational objectives in a way that less liquid strategies don't and that's one of the arguments that we put forth here.

Keith Cahill: So, many of those on the line also have fiduciary oversight of defined contribution plans. How many insights that you’ve shared today apply to DC participants in specifically retirement income?

Jared Gross: Thanks, Keith. Yeah, that’s a terrific question and the paper obviously is geared towards institutional portfolios more on the defined benefit side, but a lot of the intuition that backs this is applicable at the individual level, and is, at least to some extent, accessible via DC plan strategies.

For instance, we observe that as participants pivot from the accumulation phase of their retirement saving to the decumulation phase of their retirement spending, they will have a stated preference for income generating strategy. 

Keith Cahill: Fast forward to 2030, Jared and Pulkit and you're looking back on COVID-19, and institutional portfolio performance. What did we learn? Anything we can do differently now? Jared, maybe you start off? 

Jared Gross: Sure. Great questions. I think, probably the most startling thing that occurred in 2020. I mean, aside from the broader impact of COVID, and this kind of recognition that, you know, as much as we spend time thinking about black swans and tail risks, we are continuously surprised by them when they occur, is the degree to which the Feds intervention has impacted the markets.

And I think we all kind of understood from previous episodes that the Fed has a lot of firepower to bring to bear and their ability to by adding liquidity, smooth volatile markets, I think that was widely understood and the initial phases that intervention followed that game plan fairly closely. 

But when you observe the rapid recovery of risk assets of all types, you know, despite what remained a relatively challenging economic environment that we all are living with right now, it suggests that the ability of the markets to incorporate low interest rate expectations, and revalue future cash flows in a positive way, is really quite profound. 

And we still have to wait and see how the Fed ultimately sort of extracts itself if they're able to from this model. They were on the early stages of unwinding the interventions from the great financial crisis when this scenario came to pass, and we can only wonder how long it's going to take. 

So, you know, I think, to get back to the original question, if we look forward 10 years and then back at today, what will we have learned? My guess is that the feds ability to intervene in the markets was far greater than we expected and that has really the ability to cut off both tails. It can prevent a crisis to the downside, but it may also turn out prevent strong returns to the upside, if the Fed ultimately has to take back some of this accommodation. 

Pulkit Sharma: And I will say, yes, the starting point is very important. So flashback, October 2030, we'll be looking at where, again, due to a lot of the policy intervention where the starting points were for a lot of public and private market assets. And elections, which are hot topic right now will be a distant memory in 2030 and what will be more prominent memory is the performance of the asset and the role of income, which is critical over the next decade as you know, that's where all the certainty of outcome lies.

So, doing anything (unintelligible), or I would say overweighting the identity of outcomes, overweighting quality of returns streams is critically important and so is be flexible around labels focusing on the outcomes which investors can access from both the public and private markets today and also tapping into categories where risk premium is mispriced on some things which investors can do today, you know, you think about 10 years from where we stand today. 

Keith Cahill: Okay, I've got two questions here that both kind of revolve around portfolio construction and asset allocation. So, let me ask them, if I can combine them into one of two.

The first part of it is, as you think about portfolio construction and allocation, what tools do you have at your disposal when considering illiquidity budgets, part one? 

And then the second question is focused around funding sources. So as we work with clients, where are we seeing, or where are we suggesting that we fund some of these ideas and then pivot towards income where we funding that from? Jared, maybe start with you.

Jared Gross: Yes, sure. So, you know, the notion of an illiquidity budget is an interesting thing. We assume that the illiquidity is going to deliver higher returns otherwise, we would not, you know, bother with this. And I think the constraint we have is really about the ability of the portfolio to access capital to both make ongoing payments either to beneficiaries or for institutional support, slightly less critically to behave opportunistically as markets move and to rebalance or reallocate into opportunities as they arise. 

And for some types of investors, maybe corporate pension funds, but not exclusively corporate pension funds, to provide significant liquidity around large capital intensive events, think about a pension risk transfer transaction or something like that. So, against that backdrop you can think about the level of liquidity that's necessary. 

Most plans on the pension side typically pay out on a net basis, something in the single digits as a percentage of their assets, and conversely, hold probably 70% to 80% of their portfolio in liquid assets. So, that's a mismatch that probably presents an opportunity to become somewhat less liquid, and increase returns, while not becoming overly illiquid, and running the risk of (quiddity) problem. 

And again, as I mentioned earlier, against that liquidity need, we have to be thoughtful about the types of illiquid investments that we allocate to. So it's not to say that we abandon liquid assets and move entirely into long, lock strategies that's clearly not the right approach. But as we contemplate this spectrum of illiquidity that's available to us, it is certainly possible to create sort of tranches of the portfolio based on their liquidity structure and use that to ensure that the plan has ample liquidity to make good on its obligations, while generating meaningfully higher returns.

Keith Cahill: Excellent. How do you think about the effects of yield heavy strategies when considering liquidity? So, I’ll throw it out to both of you, maybe it makes sense to go with Pulkit, first? 

Pulkit Sharma: Yes, I think the illiquidity of yield heavy strategies kind of depends on what the end structure is, but I would say, in yield heavy strategies, if the quality of the asset pool is higher than they do (track) deductible income. So, if the idea for a plan sponsor is to use that liquidity or cash flows, which can be in the form of income distribution, operating cash flows, they can be, as Jared mentioned earlier, can be used for benefit payments. 

So, these yield heavy strategies on the private side, do offer a spectrum of liquidity. So the point is, they're not daily trading strategies, that's not the purpose of them, but they do offer various mechanisms for liquidity, income being the primary mechanism, and then ability to get the money out after a period of time as the (effect) begins.

Keith Cahill: Excellent. Jared, anything you'd add there. 

Jared Gross: Well, I think I spoke a little bit about this earlier, but as we think about the role of illiquid assets in generating higher levels of return, I think there has always been a natural break on that in the asset allocation process, because maybe investors were sort of anchored around the less liquid end of the spectrum and they were focused more on return of capital, rather than maybe the return on capital.

And to the extent that the return on capital is income driven, as focus has been discussing, that can support a higher weighting in a plan all else equal. So, there probably is work to be done around segmenting alternative allocations, not just by investment category on sort of underlying risk pool, but by liquidity bucket. 

And you know, some of the work that we've done is, at least in the paper, and the grass is a liquidity score, which relates to kind of the time horizon over which you expect to get your money back and the greater degree of income is going to bring that average life down. And maybe just referencing a point I made earlier in the call, it reduces the effective duration of the plan’s assets. 

And, you know, we don't know exactly how rising rates will impact each of these specific strategies, but it is unlikely to be positive and so a reduced duration, even across alternative assets, is probably going to be a tailwind for performance relative to what traditional strategies.

Keith Cahill: Excellent. Well Jared, Pulkit, I want to thank you both for sharing your insights and your time.

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