David Lebovitz: Welcome to the Center for Investment Excellence, a production of JP Morgan 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 core alternatives and has been recorded for institutional and professional investors. I am David Lebovitz, Global market strategist and host of the Center for Investment Excellence.  

With me today is Pulkit Sharma, Head of Alternatives Investments, Strategies and Solutions. Welcome to the Center for Investment Excellence.

Pulkit Sharma: Thanks for having me.

David Lebovitz: Before we jump in I would just like to take the time acknowledge the volatile period that we are experiencing, both professionally and personally. We are going to be releasing several episodes over the coming weeks across various asset classes and topics to help you navigate this challenging period.

If you look at markets it has been a rocky road over the past few days due to COVID-19 and the recent Fed rate cut to zero. One thing that I would like to emphasize that it is important for investors to remain focused and objective as much as they can during times like the present.

One area we would like to discuss today is core alternatives. Core alternatives we believe can help clients build better portfolios in the current environment and provide a potential solution offering stable income and a low correlation to equities.

So Pulkit, let’s kick off here. How do you define core alternatives?

Pulkit Sharma: Sure, and David I totally agree that these are truly extraordinary times and the core alternatives have a very important role to play and I will give you some definitions.  

But you and I worked on this construct for advising our investors maybe six months ago on the best offense is a good defense. I think that is what we really stand by and that is where core alternatives can play a very important role.

So what are core alternatives? They are asset classes within the private markets world which provide stable income with stability. So two to three times the income of the fixed income world.

You know today it is more three times and with one third to two thirds the volatility of equities from an outcome perspective. The word core in core alternatives we define that by considering asset classes or assets which have very high forecast-ability of cash flows with a very low margin of error. Quality of those cash flows are equally important. 

Core alternatives have roughly 70% to 100% of their total returns coming from income. And that income really comes from contractual sources.So long term leases underpin that income.  

What that leads to also is non-correlation or low correlation to the equity markets, core alternatives have typically lower levels of leverage and they are a very scalable multi-trillion dollar asset class.

And today they seem to be mispriced which is what is happening in the traditional assets. If you look at a 12 year process of the recovery, I would say the bubble have happened in the corporate debt world on the financial assets world. It hasn’t really happened or the cap rate or the discount rate compression hasn’t happened in the same extent in the core alternative space.

As we bucket the space now into three major constituents or building blocks on the core alt space. One is core real estate. Think of core real state as a category of core alternatives delivering around 4% to 5% income. It is underpinned by well-leased assets which have high occupancy. Usually a non-operating component or more cash flowing assets with low leverage.  

That is an underpinning foundational building block of core alternatives. And then there are categories which deliver anywhere from a high to 7% cash shield. So think of infrastructure assets or assets which are delivering water waste, water natural gas to end customers.

And think of mezzanine real estate assets which are assets underpinned by strong cash flow real estate properties but operating at the low level of situated capital stack. Think of also top of capital structure lending in the residential space or core private credit as another example.

And then finally there is a third building block which was moving infrastructure transportation assets. These assets the foundation for them is strong counterparty exposure and also long term leases into sectors such as energy type of assets and leasing type of assets.

So look beyond from the label all of these assets have something in common which is stable income underpinned by contractual cash flows and low volatility of returns.

David Lebovitz: So you mentioned stable cash flows and relatively low volatility. You know obviously both those things are front of mind right now given everything that is happening in markets with respect to COVID-19. I would love for you to comment a little bit on how you think core alternatives may be affected by COVID-19.

I mean do you see any direct impacts on say parts of the real estate space? Parts of the infrastructure space and arguably parts of the transportation space? I would be interested in your thoughts in a little bit more real time of how core alternatives may deal with what everybody is dealing with with respect to the virus.

Pulkit Sharma: Yes David there is an impact. The key thing to remember is what the virus is causing is a change in the macroeconomic environment. And that is sort of this how trickling down to the core alternative space. And it is winners and losers and we will talk about that.

But remember that the issue the virus is causing is a structurally lower growth environment. So those factors really play into how the individual segments within core alternatives will be impacted.

So let’s take the example of certain segments that you mentioned. Real estate, there are again going to be winners and losers. So the major segments which are impacted in real estate are retail, commoditized goods, retail, hotels have a big impact from what is happening in the travel industry.  

Anything we think which has very high of leverage are sort of multiple expansion will see a little bit of an impact. Speculated development projects, greenfield construction, land investing. All of these areas within real estate will have an impact.

There are also bright spots. The bright spots would again be going back sort of to the outcome that core alternatives that generate segments within real estate which have low beta and high income profile of higher quality of income who tend to do better.

What are those segments? We think of commercial mortgage loans. Where we are doing asset backed loans at 50% to 60% on the capital stack you can pick and choose the right type of segments, sectors and markets which is actually of prime importance today.

Mezzanine real estate investment where you are taking 60% to 80% cap restack position with the retrenchment of debt funds that is a good place to be in because you have sort of first law equity protection.

Core real estate. Real estate again has a very big label element to it. Core real estate or properties which have highly forecastable cash flows. So you are not talking about non-core. So core real estate again cash flows are very important.  

So if you have long time contraction leases could quality of in place those types of assets tend to do better. Multi-family assets tend to have more inelastic demand than say hotels.

So there you can see sort of the differences in the real estate space. Infrastructure and transport again there is going to be differences between various segments within it.

Anything which has a very strong GDP or volumetric component to it will tend to do less better than sort of more contractually cash flowing infrastructure assets.  

Anything which has spot leases, weaker counterparties or a speculative component to it will be more impacted than segments with an infrastructure in transport which has inelastic demand of its offer essential services, water, waste water, electricity distribution which tend to have very strong counterparty exposure.

So think of the large oil tankers. So energy prices moving up and down and back to spot market. And by the way, the low energy prices those types of vessels are in great demand today.

But if you have that kind of an asset with a very strong counterparty and a long term lease on it you can mitigate a lot of the up and down side volatility associated with that.

So the key points there are sectors which will do well you will have more inelastic demand component to it and which will have a lower beta and more contractual cash flow component.

And then there are some segments within the credit space as well where you are lower levered and you are more capital structure and have more secured lines of cash flows on the underlying pool of assets. Those assets again tend to be more resilient than assets which have more economically sensitive demand drivers associated with them.

David Lebovitz: So it really sounds like the key in evaluating the impacts of the spread of the virus on alternative investments is really their sensitivity to the overall business cycle and the ability for those cash flows that the assets do generate basically be locked in unless subject to the ebb and flow of what is happening with growth on a day to day basis.

Taking this one-step further, you know, obviously the Fed has been quite active here over the past couple of weeks. Last Sunday night cutting rates down to zero. Restarting QE, reopening the discount window. This week they came out and said that they are going to start buying commercial paper from non-financial entities.

Pulkit, can you talk a little bit about how this backdrop characterized by uncertainty and easy policy and more importantly market volatility. How does that backdrop lend itself to using core alternatives in a portfolio? 

In other words, how can core alternatives help offset some of the volatility that has been so prevalent in markets here over the course of the past couple of weeks?

Pulkit Sharma: Sure and as you just said David there is a lot happening every day, every week and you know there is a concerted response by the central bank and the government to boost confidence and try to fix the supply chains which are getting clogged.

But what is clear is that this is sort of leading to volatility in the market and sort of beginning of the end of the cycle and beginning of the new cycle.

And if you think of from history lesson on what happened in the last couple of recessions in 2001 which was tech driven recession and 2008 which is a real estate and financial services driven recession. This recession if it comes it is going to be more triggered by by synchronized loading of global growth.

And that basically means that what core alternative to any asset class sort of the best place to be in is where your risk premium is controlled in an environment where there is low growth.

And this volatility creates two or three things which are often (unintelligible) from an investment perspective. It creates winners and losers and we talked about one of the winners and losers in the core alternative segments. 

It also creates the idea of looking at lowering of risk within the categories you are in and sort of opening up defensive bucket or lowering the beta of your existing pool of assets within the overall portfolio and also within your alternative sleeves.

And finally one important tool which exists today which did not exist in the last couple of recessions from a core alternative perspective and actually multiple tools is that the many of strategies available in the core alternatives world has expanded. And in that expanded toolkit is important to utilize in a low growth environment.

Because all of these core alternatives have one thing in common which is they deliver low beta with higher income. And they have another thing in common which is not common in a lot of financial assets is that there is a lot of degrees of non-correlation which exists in the core alternative space.

So there is not a lot in common between a multi-family contracted asset or an oil tanker for 5 to 10 years or water distribution utility which has strong counterparty in cash flows.

What that leads to is even more important for investors is that it leads to a resiliency of income and also dampening of volatility and draw down which are key attributes which investors should look at in an environment we are in today.

David Lebovitz: I think most people can probably agree that anything which comes across as having a low beta to equities and a high income component is certainly helpful and impactful in markets like the ones we are currently dealing with.

So maybe just kind of bringing things to a close here with one final question. You know a lot of the conversation we had is about how core alternatives can help generate income. How they can provide diversification. 

But I think what is important for clients to recognize today is that with the move we have seen in both equities and fixed income there has been a lot of rebalancing in portfolios that has already occurred.

And so when we think about what comes next? And we always try to be forward looking on these podcasts. So thinking about what comes next. What are some areas within core alternatives or maybe I will even branch it out to alternatives broadly that investors can think about if they want to either rerisk or derisk?

A lot of portfolios that we have been looking at actually are coming across as being underweight risk assets given the selloff that we have seen in equities. So how do you think about using different types of core alternatives? Or again alternatives broadly to rerisk and derisk portfolios?

And then kind of the next step of that is how do you think clients should be thinking about funding allocations to alternatives if they are not already actively investing in that space?

Pulkit Sharma: Sure. I think there is a strategic and tactic element to that question. You know when we came out with our 2020 long term capital market assumptions, one of the themes there was this idea of rethinking safe haven assets and that is truly playing out today in the markets.

The traditional safe haven assets which are currencies, are precious metals, are traditional fixed income. Are doing their job either with volatility or rapidly shrinking income in the fixed income space.

So in that strategic construct we talk about roll off which core alternatives can play as a complement to those traditional safe haven assets.

If  you look at our long-term outlook again, the 10 to 15 year outlook for most core alternative categories are similar to large cap equities. While that is a longer-term view, what has happened in the last month or so is that there has been an actual rebalancing it is happening in portfolios.  

So the conversation which was more about de-risking in January and February has shifted towards a conversation about defense and being ready to sort of rerisk or being ready for the end of monetary policy tools.

And the fiscal tools really lead to an even more important role for the core alternative categories and that sort of long end of Treasury curve will actually see a little bit more challenges.

So there is going to be a demand of investors to look at assets which have long time horizon cash flows which can sort of complement that and of the fixed income world which can be complement or be a replacement for the corporate bonds or higher risk areas within the fixed income space.

So that is sort of the broader, bigger strategic view. And then, you know, it depends really on what investors should do in terms of how they are really set up.  

So they have an already existing portfolio of assets. They should try to look under the hood and see what are the types of risks they are getting? And they should look at sort of adding a little bit more defensiveness to their existing portfolio of assets.

And then for investors who are looking at these funding sources which are now available to them because of this natural rebalancing. They should look at building the foundation within the core alternatives space and also keeping room for taking advantage of the dislocations which will arrive as we go through this recovery process.

One thing which is very important more so than ever before it is important to have a strong foundation in your portfolios.  

Whether it be any asset class. So the building should survive an earthquake or the building should have a strong foundation. And the building should actually rise the most are also the buildings which have a strong foundation. So core alternatives can play a very strong role. Liquidity is important. Loading the beta off their portfolio is important and using alternatives as a source for income is critical in an environment and the uncertain environment where you are living today.

David Lebovitz: Excellent. Pulkit thank you so much for joining us today and thank you specifically for joining us on the Center for Investment Excellence.

Pulkit Sharma: Thank you.

David Lebovitz: Thank you for joining us today on JP Morgan’s Center for Investment Excellence. CFA Institute members are encouraged to self-document their continuing professional development activities and their online CE tracker.

If you found our insights useful you can find more episodes anywhere you listen to podcasts and on our Web site recorded on March 19, 2020.

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