Alternative Asset Management Outlook
The past year was quite the journey, but one defined by remarkable discovery. We developed life-saving vaccines, sent civilians into space, coined the notion of “meme stocks”, and tested how often we could use “supply chain” in a conversation, to name a few. On our team, Paul learned that a golf score under 100 is actually possible and Jamie uncovered a new title to add to her credentials – cross country fangirl (thanks to her collegiate runner son). We discovered the strength of our team in a hybrid work environment, added 12 new members globally, and grew to over $19B in AUM.
For investors, 2022 is shaping up to be another uncertain expedition. It is increasingly difficult to generate stable returns and alpha in public markets alone. Thankfully, our strategies can deliver on both fronts. In the pages ahead, we outline a roadmap of our highest conviction hedge fund and private credit strategies that we believe will generate uncorrelated alpha from near-term market dislocations and longer-term secular trends. Before venturing forward, however, we wanted to reflect on a couple of other important journeys we have embarked on.
ESG has evolved from a “nice to have” to essential for investors and we remain at the forefront of the industry driving change. In addition to assessing 100% of our managers on ESG criteria, our efforts have resulted in over 90% of our managers having a formal ESG policy.
The importance of Diversity, Equity & Inclusion is no new discovery, and it is a top priority for us. Twenty six percent of our AUM is run by diverse and female managers, which is industry leading, and we are committed to further improvement. Talent is a precious resource, and we are hyper-focused on both investing in and working with top diverse individuals. Within our own organization, Paul is co-chair of the Global Alternatives DE&I Committee and Jamie founded and leads Project Spark, a diverse and female-led venture capital investment initiative.
On behalf of our team, thank you for your continued trust and partnership and we look forward to embarking together on the journey of the year ahead.
Inflation, rising rates and geo-political tensions together led to the Jan ’22 market decline. A further re-pricing of risk assets is not out of the question – in short, volatility is back. All of this points to a challenging year ahead for many plain vanilla equity and fixed income strategies. Thankfully, market volatility is often beneficial for many hedge fund strategies. In light of the changing environment, we believe that it is time for investors to re-examine their portfolio allocations with the aim of protecting returns through new sources of alpha.
Our focus in 2022 is to build resilient portfolios. In our Balanced portfolio, Relative Value strategies are weighted at ~50%, followed by ~20% in Long/Short, and ~15% in Macro/Opportunistic, 5 to 10% in Liquid Credit and 5 to 10% in Event Driven-focused co-investments.
A rising interest rate environment tends to lead to periods of heightened market volatility and dislocation, which benefits relative value trades. An emerging trend is that of sophisticated investors using relative value hedge funds as a complement to Fixed Income – because these typically offer mid to high single digit returns; and are less sensitive to equity and fixed income markets. We believe that this strategy should offer better risk adjusted returns than simply rotating to higher risk parts of the Fixed Income universe in search of yield.
Albeit a smaller weighting in our Balanced portfolio, we expect Event driven-focused co-investments to be an important alpha generator this year. These allow us to be nimble, and to lean in and out of targeted exposures dynamically in individual companies and themes.
The Strategy Heatmap (see Exhibit 1) ranks the opportunity set across hedge fund sub-strategies including private credit and is updated every quarter. The highlights of our sub-strategy views are discussed in the rest of this document.
Exhibit 1: JPMAAM Quarterly Heatmap
Key: ⇆ denotes change from the last quarterly Heatmap.
1Q 2022 STRATEGY HEATMAP
JPMAAM VIEWS & FOCUS
Statistical Arbitrage / Quant – Forward market expectations (see Exhibit 2) suggest elevated volatility throughout the year. We believe volatility could get even higher if investors, already hurt by the Jan market decline, start to overreact to short term news. Statistical arbitrage strategies, whether using statistical or machine learning methods, tend to do well in periods of higher volatility. Given the deeper and more frequent rotations in factors (see Exhibit 3), we believe that shorter term strategies and managers that have appropriately adapted their risk and portfolio construction methodologies for such issues, have a performance edge.
Exhibit 2: S&P 1 Month Implied Volatility
Exhibit 3: Barra Equity Factors (Sector Neutral)
Cumulative Returns December 2018 to December 2021
Equity Capital Markets (ECM) – The strategy has grown more interesting of late given the strong deal flow of trading opportunities generated by IPOs, block trades secondaries, insider lock-up expiries and other capital markets activity. The number of dedicated ECM managers has also grown, and manager selection is critical given the dynamics of sourcing, deal sizing and trade structuring. While the IPO market may be relatively weaker in 2022, we expect ample deal flow, larger discounts and slightly lower competition, which should prove supportive of returns.
Multi-strategy – In a time of increased uncertainty and dislocations, strategy and asset class diversification matters more than ever. Such managers can invest in a diversified manner across SPACs, Quant, Volatility Arbitrage, Appraisal Rights and other flow / capital markets-based opportunities.
Opportunistic / Macro
Macro – The expectation of increasing policy divergence across countries, rising volatility across fixed income, FX and equity markets as well as the prospect of higher U.S. rates and elevated inflation sets the stage for an attractive investment scenario. We expect compelling opportunities across fixed income, commodities and FX on both a directional and relative value basis. While our focus remains in developed markets, we see additional opportunities in emerging markets as heightened volatility and dislocations enlarge the opportunity set.
Crypto – Digital assets are too big to ignore. Given the relative scarcity of sophisticated capital in the crypto space, we are optimistic that hedge funds can generate superior risk adjusted returns. Strategies that have caught our attention include arbitrage strategies, systematic futures trading and very selectively, directional trading of tokens based on fundamental views.
Prior to investing, investors should understand that the risks in crypto investing are significantly different from traditional investing (see Exhibit 4).
Exhibit 4: Some Important Risks of Crypto Investments
Long / Short Equities
One of several factors underscoring our constructive alpha view on LS Equities is the high-performance dispersion among stocks, which tends to create opportunities to take advantage of mispricing.
Corporate Governance – For much of the last 18 months, we have been excited with the environment for activism given the dispersion in markets (and laggards therein), inexpensive financing and favorable regulatory / shareholder developments. This view has been rewarded through our investments with activist hedge funds especially in our co-investments (see Exhibit 7). In 2022, we expect to participate in activist situations but will be very selective given higher financing costs and a decline in CEO confidence.
Low-net LS - Despite the impressive ascent of most developed equity markets last year, it was a challenging year for our long / short equity managers especially in Technology and Healthcare. While rising rates are a headwind, stock dispersion should normalize as investors look to protect gains by rebalancing their portfolios away from high growth names, towards quality and companies with a clear path to earnings. We expect agile stock pickers to find above average opportunities on both the long and short side; there may also be upside potential in selected names in oversold sectors. For example, Biotech and China stocks have sold off materially both on a relative and historical basis (see Exhibit 4 and 5).
Exhibit 4: Biotech Returns relative to Market
Exhibit 5: China Internal Returns relative to Market
Equity Event Driven
The opportunity set across equity event driven strategies is strong and especially attractive in certain cases including appraisal rights situations, restructuring opportunities, and SPACs.
SPAC investors had an uneven experience in 2021 given speculation in and out of the market which has distorted values – making this an area to pay attention to in 2022.
There are three areas we like in SPACs:
- Sponsor shares of credible players can be very lucrative given the low-cost basis and the high potential upside
- To keep investor demand healthy, sponsors are overfunding trusts, issuing more free warrants and reducing the holding period of SPACs (see in Exhibit 6)
- Dynamic trading of warrants in announced and completed deals
Exhibit 6: Significant improvement in SPAC investor terms
Co-investment Trades - When the beta gets tough, get alpha. We expect to spend more time this year looking for returns that are driven by specific catalysts and are less reliant on rising (or falling) markets. These trades can be very time-sensitive which is a challenge, but it allows us to put on very targeted exposures and to size dynamically as the catalysts play out (see Exhibit 7).
Exhibit 7: An Example of a Sustainable Activist Equity Opportunity
Liquid credit – Dislocation and dispersion has been low in most parts of the liquid corporate credit market which makes the opportunity set generally less attractive for long short credit managers.
A long accommodative Fed combined with investors’ searching for yield have kept spreads very tight (see Exhibit 8) and US HY spreads have now averaged around 400bp over the last few years – the last time this happened was pre-GFC. In a rising rate environment, loans appear far more attractive than HY bonds, given their floating rate nature.
The risk adjusted opportunity set appears narrow and includes restructuring and/or stressed opportunities in corporate credit and niche segments like US residential non-QM mortgages and bridge loans in US commercial real estate assets.
Exhibit 8: US HY Default Rate and Spread to Worst
Private credit remains one of our highest ranked sub-strategies, offering better income and a much better risk reward than high yield and emerging market debt. Given a strengthening dollar and the relative strength of the COVID response in the developed markets, this is where we are inclined to focus. That said, whilst the economy looks to be in good shape in many parts of the developed world and defaults remain low, investors should be selective as high leveraged companies will feel the impact of rising rates disproportionately.
- Corporate Direct Lending – Lenders have done well through COVID which has led to large inflows into new and follow-on lending funds. Investors should make sure they understand the risks in their portfolios as higher level of competition can lead to eroding yields and credit quality.
- US residential mortgage origination– Housing has supply/demand tailwinds for the next several years at least especially as the US consumer has emerged from the pandemic with an even stronger balance sheet. Competition in this area is limited for now which is good for investors.
- Consumer Credit – Barriers to entry are very high to do well in this relatively complex segment and players need a range of capabilities in structuring, financing, monitoring, risk management, fraud prevention and recovery management. Returns can be very strong for investors who understand and are comfortable with the risks.
- Infrastructure - We continue to see many opportunities in areas like Clean Energy where demand for capital far outstrips supply especially for smaller scale utilities and developer bridge financing.