The World of Alternative Investing
Tune in to hear Dr. David Kelly and Anton Pil, Global Head of Alternatives, discuss the latest in alternative markets.
David Kelly:
To be a good long-term investor, you need courage and you need brains, but you need them in different quantities at different times. In the depths of a bear market, you mostly need courage, since it's almost a no-brainer that the economy and financial assets will recover. In the bull market, it's mostly about brains, since when valuations are higher, investors need to pay close attention to both asset allocation and security selection. Today's environment is one where elevated valuations say one thing and recession risks say another, requiring investors to take a close look at the opportunity set and the investment tools at their disposal.
So please join me for our eighth season of Insights Now, entitled, 'The Investor Toolkit,' when I sit down with a number of the pioneers and thought leaders at JP Morgan Asset management specializing in different parts of the investment toolkit, alternative assets, model portfolios, actively managed ETFs, retirement strategies and portfolio construction. Employing brains in ever-changing markets is no easy endeavor. But through these conversations, we hope to bring clarity and highlight new strategies for the significant effort of positioning investment portfolios for the long run.
On this episode, we're going to dive into alternative assets. Alternatives have seen remarkable growth in the last decade, providing new strategies to invest in both public and private markets and better ways to generate alpha income and diversification than traditional stock bond portfolios. There's a wide range of alternative assets, each with their own benefits and risks. After many years in which only the wealthiest investors had exclusive access to alternatives, they've now become more accessible, and the growth of their collective asset size means that all investors increasing need to understand what is happening in alternative markets.
For this conversation, I'm very glad to be joined by the global head of alternatives at JP Morgan Asset Management, Anton Pil, so let's get started. Anton, welcome to Insights now.
Anton Pil:
It's great to be here.
David Kelly:
We've obviously got a significant suite of alternative investments here at JP Morgan. Can you talk a little bit about the overall scope of this business?
Anton Pil:
Yeah, so this is a pretty sizable part of our overall business here at JP Morgan Asset Management. We're a little unique in that we touch most of the different sections of alternatives, from hedge funds, to real estate, to infrastructure, private equity, private credit, liquid alts. We do pretty much anything that is not associated with directly long equity or bonds, and it's a sizable market for us. We manage a well over 200 billion and a very rapidly growing business.
David Kelly:
All right, well let's take a spin. Let's go through these asset classes here. To start with, how would we look at hedge funds?
Anton Pil:
All right, let's start with that little slice first.
David Kelly:
Yeah, exactly.
Anton Pil:
By the way, it's funny you chose that one first because that's the one where I think most people haven't been talking about it for the last four or five years, because hedge funds generally give you a return that's cash, plus some target, usually three to 5%. And when cash rates were zero or 1%, at 4%, most people didn't really care that much about them. But now that cash rates are back north of five and hedge funds are targeting eight to 10, we've seen a lot of inflows in the last six, 12 months, and because you've got that targeted return number that's closer to 8% or 10%.
But probably equally important, last year in particular was a year that showed the value of owning a hedge fund from a diversification standpoint, low correlations to broader markets and in an environment where both fixed income and equities underperformed, this actually helped get that diversification. And what I'm finding that clients are doing today is they're increasing their hedge fund allocations because it allows them to barbell their long equity positions longer. So they're really using it as a diversifier in their portfolio. In the old days, people wanted hedge funds for the highest possible return. Today it's actually the diversification element is almost as important as the return element.
David Kelly:
And of, course 2022 proved the need for [inaudible 00:04:03]
Anton Pil:
And then 2022 proved the need for that.
David Kelly:
That's why it [inaudible 00:04:06].
Anton Pil:
Exactly. And people sometimes ask me, "Well, why would they be have this low correlation?" And in my mind it's quite simple. They can go short. You don't have to own anything. You can own cash, you can go short, and we generally favor the strategies that are not directional because those are the ones that generally add the most value in the portfolio construction.
David Kelly:
All right, Okay. This is rapid fire here. Let's move on to private equity. What are your thoughts about private equity right now?
Anton Pil:
Private equity is a little bit of a tale of two cities. We obviously had some significant sell offs in public equities, even though a lot of that has come back this year. Private equity valuations, actually, through all of that, actually stayed remarkably stable.
I think some of that is justified, some of it is maybe a little bit more of a stretch. I think about private equity as if you own private equity today that was built or acquired using a lot of leverage, I think a lot of those valuations will become stressed and just as public markets.
But half the market in private equity didn't necessarily use leverage. Leverage wasn't or financial engineering wasn't the main source of return. It really is the changing, especially in the middle market space, managing the company in a different way to generate value rather than using financial engineering. That space in particular, I think, is going to continue to do quite well as general earnings continue to be relatively healthy across all markets, both public and private. The other thing is that it's hard to compare the returns, for example of the S&P 500 and then just try to compare that directly to private equity. And one of the reasons for that is that the composition of private equity is just very different. It's heavily overweight to tech, and I believe healthcare, relative to public equities. Just trying to compare the two, it doesn't really work that well, especially given the large run-up in tech we've seen. I think private equity, it'll be some good vintage years coming up. I think we're going to probably have some valuation struggles in the next 12, 24 months with [inaudible 00:06:23] rates staying higher for longer.
David Kelly:
I guess another area of some question with regard to valuations is private credit right now.
Anton Pil:
Yeah, look, that's probably the area that has seen explosive, enormous growth in the last decade. I think estimates are from in the trillions of dollars for the size of this market. And it makes sense. The market's going to continue to structurally grow as regulations on banks continue to constraint bank balance sheets as a main source of lending for all kinds of activity from private equity, to commercial real estate, et cetera. So the growth of that market is going to continue unabated, and I actually feel quite strongly that that's the overall market allocations there container grow.
However, having said all of that, I think it depends a little bit. A lot of private credit is floating rate and the liabilities are SOFR, the old LIBOR, plus a spread. And in an environment where SOFR cash rates have risen, the borrowing costs have risen real time, which is very different than people who fixed their borrowing rates. So I do worry a little bit that private credit on the corporate side is going to be vulnerable to higher rates or rates staying higher for longer. The private credit market really developed after the global financial crisis. We've never really seen a big default cycle since then. I think private credit performance is going to be tied a little bit to what happens to the economy. If we do see a either recession or stagflation that causes an increase in default rates, I think we're going to be testing private credit and I think some people will be disappointed with the performance.
David Kelly:
And also, I guess this is an example of how the economy's changed over time. The Federal Reserve really doesn't know what these higher short rates might do to the economy because you've got a whole new transmission mechanism here, which they really don't have much experience in monitoring. So it's one more reason why they really ought to [inaudible 00:08:33]-
Anton Pil:
It's actually quite fascinating, because I think they wanted to... All this regulation is intended to make the bank safer. And indeed, the banks will probably be safer through the next downturn and credit cycle, but all we've really done is move that risk to another part of the market that has less transparency, and I guess maybe that's the point. It'll make the banking sector more stable, but I think the reality is the risk in private credit is still there. There's been a lot of amend and extend taking place. In other words, where lenders have been changing the terms for borrowers to give them more time, et cetera. And I think as long as rates don't stay high too long or economic activity falls too much, you'll probably ride through this. But to think that private credit is going to be immune to a down cycle, or frankly, have a similar experience to high yield, I think could be a stretch.
David Kelly:
I think 2024 will be very interesting.
Anton Pil:
Absolutely. And I think it actually could be healthy for that market to actually shake it up a little bit and have managers prove that these covenants, et cetera really work. Because I think otherwise, it'll always remain a little bit of an unknown, and I do think it's healthy for that market to have a little bit of that shakeout.
David Kelly:
Okay, well let's turn to perhaps a very traditional alternative, just real estate. Obviously, it's a very wide swath of territory in terms of... How do you think about offers versus multifamily versus data centers?
Anton Pil:
This is one where I probably have a little bit of a view that's perhaps a bit controversial. I think office is being tainted with the work from home brush, and I think people have... It's overshot. I think the work from home aspects of the economy are slowly changing. And I can tell you, since Labor Day, the statistics, we own 850 odd buildings, I can tell you that the occupancy rates of those buildings have changed dramatically this. Labor Day. We're not, obviously, at pre-COVID levels, but in many cities, for example in Seattle, we're talking about 20 30% increase in attendance rates in office. What I would caution is that there are two types of office. There's the office where everybody wants to work and there's the office where nobody wants to work. And that trend existed pre-COVID, pre-work from home.
A lot of office space across the country is going to have to get upgraded to modern standards. Those buildings are in trouble and they were in trouble pre-COVID. COVID just accelerated the haves and the have-nots in the office space. But to think that the good offices are going to struggle, I think that's a mistake. I think the work from home aspects are going to get more broadly integrated, but I think as you see more companies, whether it's Zoom or others continue to push for productivity, they're pushing employees back to the office. And what's taken place is during COVID, a lot of people got rid of office space. And as everybody's coming back, as many of you know who are probably working in an office, it's getting more and more crowded. So we see in our top buildings we have demand and we have pricing power. I do think it's a little bit in... Just don't think all office is the same. I think that would be the takeaway.
On the flip side, the exciting parts of the market, multifamily logistics, so think industrial warehousing for e-commerce, those have done extraordinarily well and have continued to do reasonably well. I'm probably a little bit more worried about those. On the multifamily side in particular, there's been a lot of construction taking place, and in the next 18, 24 months, we may end up with a bit of an oversupply in a number of parts of the country. I'm turning much more cautious on multifamily. Logistics, I would say, is probably a little bit more tied to just the general economy. The total, I think with a lot of disruptions around logistics during COVID, you are seeing the need for more warehousing as just in time has been reevaluated.
And so, I do think there's a repricing taking place in those sectors. But in logistics, I think it's more like a fixed income repricing. You have the equivalent of a bond cashflow, so you need to readjust your price to make the return or the cap rate higher. And that makes sense. Bond rates are higher, so those rates should be higher. But there is a commercial real estate debt reckoning coming in the next 12 to 24 months. That will be interesting to see. That could put further pressure on the overall real estate market, but it's also probably the most well telegraphed risk out there. And so, to some degree, a lot of the current valuations, I think, are pricing in a number of those risks.
David Kelly:
Okay. That's really interesting. That's not exactly a consensus view on the distribution risks in real estate. Another thing where I think probably you and I disagree a little bit is on the direction of inflation, because I feel pretty good about inflation coming down to 2% by the end of next year.
Anton Pil:
Yeah, I'm not feeling so good about that.
David Kelly:
You're seeing plenty of inflation in the real estate sector.
Anton Pil:
This also might have to do with our backgrounds, having grown up in Brazil with hyperinflation, I might have a part of my brain that has still trauma associated with inflation. So to your point, I might be slightly biased. But I do worry that if I look at our real assets portfolio, our rents have been coming down, but they're nowhere close to the level. They're coming down from... We used to increase rents in multifamily in the beginning of the summer. I was looking at our year-on-year numbers were closer to 15% year-on-year increases in rents. Those numbers have meanwhile dropped to 8 to 10%, but they're not 4. And so, I worry that yes, we are lowering the amount that we're increasing our rents, and frankly the same is true in infrastructure or even on our forestry products, but it's still going up, and it's still going up at rates that are much higher than pre-COVID when rates were much lower.
So I think we all acknowledge that clearly inflation pressures are coming down. The question is, will they stabilize at a 3, 3.5, or stabilize at the 2? And I think that's the big debate you and I have, is like I'm more worried that the stickiness we're seeing, especially in our infrastructure where a lot of things are lagged, often we get permission to increase prices 12, 24 months in arrears, that there's still more of inflationary pressure to come. That's probably the difference in underlying views that we're still on the real asset side, we still have quite a bit of pricing power.
Now, whether it lasts six months from now, I don't-
David Kelly:
Well, exactly. And perhaps my view is more to do with commodity prices and also I think wages still are not as strong as they ought to be, given the tight [inaudible 00:15:50] labor market. But we'll see.
David Kelly:
We'll see. Okay, so we're almost done going around the circle of alternatives here. But one last piece, real assets outside of commercial assets, things like forestry and infrastructure. What do you think there?
Anton Pil:
It's significantly increasing demand, whether it's infrastructure. And infrastructure, think either water, sewer plants, but also things like windmills, solar plants, et cetera, or transportation assets. If I think of L&G ships and forests, we invest in all of those on behalf of our clients, and the demand for all of those asset classes continues to increase and be very high.
And it's quite fascinating. The demand is really coming for as an alternative to traditional fixed income. I think people have gotten a little bit worried, at least after last year's experience, that I need other stable forms of just cashflow and fixed income, but where the price is also a bit more fixed. And so, some of these asset classes are fairly new in the United States, for example. Infrastructure has been a very well-developed asset class in Europe and in Australia for a very long time and had large allocations. In the United States, this is just beginning.
Historically, the United States really covered its infrastructure spend, et cetera, through the municipal bond market, and that's beginning to shift as more and more things are privatized. And the investors that are investing in these asset classes are looking for a very stable form of cashflow, very predictable, often contracted, and often with very little variability. And if there is variability, it'll be based on inflation. So if you think of your local municipality or you think of a rate setting agency, the benchmark that usually everyone starts with is inflation. And so, therefore your cashflow is inflation plus whatever.
And I think after the inflationary numbers from the last 12 months, more and more clients have found out or figured out that they don't really have enough assets in their portfolio that actually will benefit from higher inflation.
And so, we've seen that double demand coming in, one, for a stable form of cash flow, and another for something that gives me some upside if inflation ends up being a surprise on the high side. Infrastructure gets you that through usually higher cash flows from water or sewer payments or energy payments. And on things like forestry, you've got an asset that's... A tree grows 8 to 10% a year and whose value is associated with inflation and so is land. So both of that as an asset class ends up being one of the higher beta trades on inflation. And I think those two characteristics have seen a lot of money in the United States flow to those asset classes, as a bit of more of fixed income proxy frankly than anything else.
David Kelly:
And that sort of leads me to my penultimate question here, which is there is growth in the use of alternatives even with lower income investors or people who've got less wealth, but where does the whole basket of alternatives fit into a portfolio? Do you reduce your equity allocation or reduce your fixed income allocation to adults?
Anton Pil:
I would say 15 years ago it was all about risk-taking. And so, a lot of it came out of equities. And that's really changed with five or 10 years of systemically low rates. [inaudible 00:19:55] rates that kept falling, more and more assets started coming out of fixed income as the risk adjusted returns of some of the newer asset classes and alternatives became more attractive. Today, it's in many portfolios you'll see private credit as being used as a bit of a proxy for fixed income. You'll see private equity as a proxy for the equity markets, and then you'll see infrastructure, real estate, forestry, et cetera, and hedge funds being used as that diversifying bucket that allows you to toggle your public markets up and down.
And those numbers are significantly greater than they used to be. I would say institutionally we've seen... A general institution with a very long time horizon today can be 15 to 25% very easily in alternatives. And in some cases with people who have pension plans with very long-dated liabilities, those numbers can be north of 50%. It's trickling down a little bit in the sense that it depends a lot on your time horizon. If your time horizon is very long, those numbers end up being, oftentimes, almost as much as half of someone's portfolio. If your time horizon is shorter, then it obviously starts shrinking.
David Kelly:
And finally you've witnessed, I guess I witnessed also a lot of growth over recent years. I mean, as you said, the allocations are much bigger and there are more investors involved, and a lot of individual investors have some alts in a portfolio now in a way they didn't before. What effect does all this investor interest though had on valuations in the old space?
Anton Pil:
Yeah, it's a fascinating development, especially the introduction of more individuals into the asset class. I think overall alternatives is slowly democratizing, which means that, I think, between government and regulators and asset managers, there's a recognition that the same role alternatives has played for institutions for the last two decades, it probably makes sense for the appropriate individual clients who also have allocations to these asset classes. And in many cases, it's the stability of valuation. I know some people want to see their valuation second by second. The reality is the vast majority of people don't need that. And actually, it can hurt their economic behavior if they are over-sensitized on what's happening second by second.
I think there's been a recognition that as more private markets have grown, private markets in particular have grown, that there's a need to democratize this. That if you are allowed to use a ride-sharing or you can stay at a shared residence hotel type thing, but you're not allowed to invest in those companies, but you can use them, but you can only invest in them after they become a public company as an individual, there's a bit of a disconnect there. And I think there's a recognition that that democratization has to take place.
But it does come with a side effect. And we've seen this already real time in Europe. For example, on wind energy in Europe, we have a number of pretty large wind installations across Europe that we were buying at fairly healthy double-digit valuations. A number of individual retail vehicles were created specifically around wind. Wind valuations in Europe are now in the high to lower single digits, mid single digits. And so, there's this cash inflow has really changed valuations, almost to the point where I think some individual investor groupings are probably going to set the marginal valuation.
Now, that's very supportive longer term for early entrants and alternatives, but it does mean that the relative valuation over time... I mean, look, individual investors represent a huge portion of investible assets around the world, and their current allocations to this are very small. I do think it will change valuation metrics somewhat over time, but.
David Kelly:
It also emphasizes why it's important to know what you own-
Anton Pil:
100%
David Kelly:
-[inaudible 00:23:54] investor.
Anton Pil:
Absolutely. And also, this is like the early bird gets the worm thing, is there's definitely some degree of that, I think, in the beginning. That's why I'm happy we're doing this, because I do think it's important to understand what the different forms of alternatives are available and are going to continue to become a bigger portion of everyone's portfolios over time.
David Kelly:
Yeah. Fascinating. Listen, thank you so much, Anton, for joining us this.
Please tune into our next episode when I'll be sitting down with Brian Lake, Global Head of ETF Solutions here at JP Morgan Asset management, for discussion on the evolution of innovation in finance, and the role that active ETFs can play in providing investors with better ways to generate alpha. And thank you all for watching.
Anton Pil:
Thanks, David.
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