Core alternative assets deliver what public markets cannot
The challenges facing investors seeking to build portfolios capable of generating attractive returns with acceptable levels of risk may never have been greater. The traditional 60% stock/40% bond portfolio mix that has worked effectively for the past 40 years needs to be reconsidered. Core and hybrid alternative asset classes that offer returns in line with investors’ historical objectives along with appealing risk/reward characteristics may be among the most promising solutions.
In this paper, we explore how an allocation to a portfolio of core alternative assets can provide a strategic substitute for traditional public assets and improve portfolio outcomes (Exhibit 1). We focus on the core foundation of the alternatives building blocks - core alternatives, where the majority of return from these scalable asset classes is derived from long-dated, stable cash flows - thereby offering resilient income and strong diversification.
Core alternative assets can range from more fixed income-like alternatives, such as core private credit, to “hybrid” categories, such as private market core real assets that can offer both a steady income and some capital appreciation over time. Finally, there are lower volatility equity-like alternatives such as all-tranche, low-volatility, real asset securities.
Exhibit 1: Core alternatives can provide significant benefits relative to public equities and fixed income
J.P. Morgan Asset Management. For illustrative purposes only.
A portfolio with a foundation of core alternatives could potentially provide higher return potential and lower overall risk compared to that of a traditional balanced portfolio. Drivers of performance include:
- Sourcing return from predictable high-quality cash flows, with some growth potential
- Low correlations and reduced downside risk and volatility vs. public equities
- Improved resilience to inflation and rising rates vs. bonds
We believe that a diversified portfolio of core alternatives can deliver meaningful outperformance vs. both equities and fixed income over the forward horizon in the next 10 – 15 years (Exhibit 2). An approximate performance premium of 200-300+ basis points (bps) over public equities and 500+bps over fixed income seems achievable, with strong public equity diversification and much lower downside risk than equity. There are some tradeoffs, including a reduction in the level of liquidity relative to what is provided by public markets. However, our analysis suggests that most investors have sufficient exposure to liquid assets so a 10% or more move to core alternatives is easily manageable.
Exhibit 2: Core alternatives are a potential substitute for equities, fixed income or both
Adding core alternative assets as a substitute for bonds, stocks or both
The core alternatives solution is a powerful tool that may improve returns by allocating from bonds, de-risking portfolios by allocating from equities, or creating a balanced approach between the two. A mere 10% allocation can materially improve portfolio outcomes (Exhibit 3). For example, annual approximate expected return can increase by 50bps when re-risking from bonds while value-at-risk can be improved by 1.9% when de-risking from equities. Additionally, core alternatives can complement traditional financial alternative categories such as private equity and hedge funds by diversifying the alternatives allocation in new directions, providing for more resilient long-term outcomes than traditional alternatives.
Exhibit 3: Adding core alternatives allocations to traditional portfolios may improve outcomes
J.P. Morgan Asset Management Global Alternatives Research.DISCLAIMER: Projected performance is not a guarantee of comparable future results. Diversification does not guarantee investment returns and does not eliminate the risk of loss. Forward-looking metrics are USD, net of management fees, based on 2021 Long-Term Capital Market Assumptions (LTCMAs). (1) Target return assumes the reinvestment of income and is a forward-looking metric based on 2021 LTCMAs. (2) Equity beta and Premium over Inflation are forward-looking statistics based on 2021 LTCMAs. (3) Downside risk is measured as forward-looking value at risk at 95% confidence level. (4) Private equity is typically the most illiquid and comes in the form of long lock-up periods of up to 10-15 years. Hedge funds are less illiquid, with lock-ups typically ranging from 30-90 days or more. Core alternatives illiquidity is between those two structures.
The importance of thoughtful portfolio construction within core alternative assets
The low cross-asset correlations within the core alternative investment universe result from fundamentally distinct return drivers across the underlying asset classes. The various components of a core alternative portfolio should be assembled so there is low correlation between each component, allowing investors to capture higher returns with less volatility than a more standalone allocation to the individual core alternative sleeves (Exhibit 4).
Exhibit 4: Core alternatives can potentially deliver better and significantly more resilient outcomes vs. standalone core/core+ alternatives.alternatives component asset class exposures. Individual core alternatives exposures may come in the form of core alternatives such as real estate, infrastructure, transport, natural resources, alternative credit/direct lending, across equity and debt structures and private and public markets.J.P. Morgan Asset Management Global Alternatives Research. DISCLAIMER: Projected performance is not a guarantee of comparable future results. Diversification does not guarantee investment returns and does not eliminate the risk of loss. Diversification does not guarantee investment returns and does not eliminate the risk of loss. (1) Expected return, volatility and expected return/volatility are calculated using 2021 LTCMA data. (2) Expected downside risk is measured as forward-looking value at risk at 95% confidence level. (3) The portfolios assume annual rebalancing. (4) Individual core alternatives average is the simple average of the underlying core
Putting the alternatives trade-offs in context
Manager dispersion in the private markets has historically been greater than in the public markets, placing greater emphasis on manager selection for private market investors. However, historically there has been significantly less manager dispersion in core alternatives as opposed to non-core alternatives (Exhibit 5). Interestingly, core alternative assets have high intra-category dispersion, which creates the potential for alpha generation through a dynamic and active allocation. Therefore, active management across different asset types matters more than manager selection for core alternative assets.
Exhibit 5: Manager dispersion is far more pronounced in non-core alternatives than in core alternatives
Cambridge Associates, HFRI, Lipper, NCREIF, J.P. Morgan Asset Management Guide to Alternatives 3Q 2021; data as of September 2021. Core alternatives are represented by core real assets; non-core alternatives are represented by hedge funds, private equity, and non-core real estate. Manager dispersion is based on the annual returns for U.S. core real estate over a 10-year period ending 2Q 2021. Hedge fund returns are based on annual returns from February 2011 – January 2021. U.S. non-core real estate, global private equity and U.S. venture capital are represented by the 10-year horizon internal rate of return (IRR) ending 1Q 2021.
One of the trade-offs of a core alternatives allocation is its relative illiquidity compared to public market assets. When viewed on an illiquidity spectrum that includes the full range of private investment strategies, core alternatives offer a “hybrid” liquidity profile with relatively shorter duration lock-up periods and higher levels of cash flows than are available in non-core private markets. In Exhibit 6, we show that core alternatives may generate return multiples equivalent to those of much less liquid strategies with longer lock-up periods, such as private equity. This makes core alternatives a compelling component of an investor’s illiquidity budget, as either a foundational alternatives allocation or a complement to private market strategies with long lock-up periods.
Exhibit 6: Core alternatives seek to provide net multiples similar to those of long lock-up private strategies with higher liquidity
For illustrative purpose. Projected performance is not a reliable indicator of current and future results. Net Multiple on Invested Capital (MOIC) denotes the total value generated for every $1 invested, over the course of the time horizon, net of all fees. The net MOICs shown above are calculated based upon forward-looking J.P. Morgan Asset Management 2021 LTCMAs data. There can be no guarantee the net MOIC will be achieved. An investor should not expect to achieve actual returns similar to the net MOICs shown above. The net MOICs are for illustrative purposes only and are subject to significant limitations. Non-core alternatives are representative of long lock-up private alternatives (e.g., private equity).
The closing argument for core alternative assets
Stocks and bonds will continue to dominate most investors' portfolios, despite well-founded concerns as to whether these assets' performance contributions will be equal to those of the past. Investors need solutions that can improve returns without adding risk. The core alternatives can deliver stable returns in excess of public markets while also providing attractive downside risk protection along with resiliency to inflation and rising rates.
Core alternatives can potentially be higher returning substitutes for fixed income and equities. Relative to more opportunistic private investments, they can potentially offer lower volatility, improved downside risk, more equity diversification and better liquidity. In a challenging public market environment, expanding exposure to private markets - especially via core alternatives - is a powerful tool for investors.