Hello.

This is David Kelly, Chief Global Strategist here at J.P. Morgan Asset Management and I'm excited to walk you through the themes from the 22nd quarterly edition of the Guide to Alternatives, which we launched back in 2019. Our goal with this guide is to provide a comprehensive overview of the alternative investment landscape, with a deep dive on specific sectors within the overall asset class. We attempt to do this clearly and with a minimum of jargon – but if you see things that we should add, subtract or clarify in this guide, please let us know.

Before looking at specific sectors, let’s get started with three basic questions: First, why should an investor consider adding alternatives to a portfolio? Second, what are the basic investment characteristics of different sectors and how can they be used to improve portfolio performance and, third, why is manager selection so important in the alternatives space?

Let's start with the question: Why alternatives? Many investors have an allocation to alternatives, but many have neglected them altogether in favor of a more traditional 60/40 portfolio – that is 60% in U.S. stocks and 40% in U.S. bonds. While 60/40 portfolios have provided very strong returns for many decades, this has come with a cost measured in higher valuations, less diversification and diminishing portfolio yields.

On page 5 of our guide, we illustrate this by looking at a concept we call the “earnings/coupon yield” on a 60/40 portfolio. This is constructed by taking the foreword earnings yield on the S&P500 multiplied by 0.6 added to the yield to worst on the Bloomberg U.S. aggregate bond index multiplied by 0.4. This analysis shows that the 60/40 portfolio has become progressively more expensive over time as we show on the left of the page. Moreover, as we show on the right of the page, those higher valuations have consistently pointed to lower long-term returns going forward.

Turning back to page 4, we revisit the idea that when stocks zag, bonds are supposed to zig. This negative correlation worked well from 2000 to roughly 2021. However, it's important to note that in the 1970s, 1980s and 1990s, bonds and stocks generally moved in the same direction. This has also been the case in recent years as sharp swings in inflation have first hurt and then helped both stocks and bonds. In short, there are many times, including recent years, when bonds failed to provide the natural hedge to stock market swings that investors have come to expect.

And then there is the issue of income. On page 6, we show the combined dividend and coupon yields from a 60/40 portfolio both in nominal terms and subtracting out inflation. The reality is that as stocks and bonds have appreciated over the years, dividend and coupon yields have fallen making it difficult for investors to generate income from a 60/40 portfolio without resorting to selling principle.

Alternative investments can address some of these issues. However, an important question is which alternative should you employ given a particular shortcoming in a more traditional portfolio. Page 8 attempts to address this question by highlighting the different roles different alternatives can play in a portfolio. From page 8 we can see that if income is your goal, you might want to consider private credit and infrastructure. For total return, you could look at transportation, private equity and venture capital. Finally, if you are aiming to diversify your portfolio, transportation and real estate are generally uncorrelated with a traditional 60/40 portfolio.

On page 9, we highlight the importance of selecting the best managers in the alternative space. This chart shows a relatively narrow degree of dispersion among managers in publicly-traded global equities and fixed income. However, it shows a yawning performance gap over the past decade between the 75th and 25th percentile managers in areas such as non-core real estate, private equity and hedge funds.

Now for the deeper dive. Turning to page 22, we look at commercial real estate. For many people, the phrase “commercial real estate” evokes images of emptied-out office buildings in the wake of the pandemic, to be followed by non-renewed leases, rising vacancies and falling asset values. However, as we show on page 22, while vacancy rates are high and rising in the office space, they are at much more manageable levels in the retail, industrial and residential spaces.

Looking specifically at offices, there are clear signs of continuing distress. According to Jones Lang Lasalle, we have now seen negative net absorption in the U.S. office space in 15 of the last 16 quarters, with tenants leaving and leases expiring. However, as we show on page 24, this the market is gradually healing though record low new office starts and the conversion and demolition of existing structures.

In the retail space, while some traditional retailers are struggling given competition from online competitors, there is significant growth in consumer service sectors, as we show on page 25, with restaurants, gyms and health facilities occupying malls that might otherwise have very low occupancy rates.

Finally, residential commercial real estate is seeing very strong growth as affordability is locking many potential home-buyers out of the ownership market, increasing the demand for rental real estate. As we show on page 27, this isn’t just apartments but includes single-family homes and townhouses, as renters demand a wider variety of living spaces.

Turning to infrastructure, page 39 highlights the unusual attributes of utilities as private sector investments. Utilities will normally not be a source of double-digit returns. However, as we show on the left-hand side, in an inflationary environment, regulators will tend to grant utility requests for higher rates as it is in the regulator’s interest to avoid a situation where their local quasi-monopoly seller of water or electricity goes out of business. In addition, as we show on the right, spending on utilities also tends to hold up well in recessions, making this an asset class with some protection against both inflation and recession dangers.

Page 40 looks at climbing global temperatures and sources of greenhouse gas emissions. The chart on the left shows what looks like an exponential pattern in rising global temperatures with 2023 seeing the highest global temperatures in modern history. Early data from 2024 suggest that this record could well be exceeded this year. On the right-hand side we show emissions by sector. It is notable that neither global shipping nor air travel are particularly large contributors to greenhouse gas emissions. However, all sectors will be impacted by regulations designed to combat climate changes and regulatory carrots and sticks will be important factors for returns going forward across multiple sectors.

One broad argument for investigating private alternative investments is that public markets are occupying a diminished share of the opportunity set. This is clearly the case with private equity, as regulations, such as those included in the Sarbanes-Oxley Act, reduce the incentive to be a publicly-traded company. This can be seen on page 48, both in a diminished number of companies listed on major stock exchanges and an increase in the median age of companies when they engage in an initial public offering.

That being said, private equity is experiencing its own pressures. As we show on page 55, valuations, as measured by enterprise value or EV divided by trailing earnings before interest, taxes, depreciation and amortization, or EBITDA, rose throughout the last decade and has not fallen, even in a period of higher interest rates. This could be contributing to a sharp decline in private equity exits which we show on page 53. This, in turn, has led to a ramp-up in volume in private secondary markets as limited partners try to redeem cash from their investments. Overall, this may present opportunities to managers with available liquidity and the ability to assess the true value of private equity positions.

Finally, turning to hedge funds, on page 77, we show that, over the past 30 years hedge funds have largely succeeded in protecting portfolios in times of equity market volatility. It is also the case that since many hedge fund strategies use cash as collateral for long-short strategies, higher cash rates tend to result in better returns as we show on page 80. However, it must be stressed, as we show on page 73, that there is a huge dispersion in performance across hedge fund managers.

In summary, understanding why alternatives are important, which alternatives to consider, and who should manage them are all crucial. Our Guide to Alternatives will help you tell your story and best adapt to meet the needs of our clients. Thank you for listening. If you have any questions or would like to learn more about our Guide to Alternatives visit our website at jpmam.com/insights

091h242706210356