Investors looking for ways to improve performance in a low return world should consider a largely untapped resource in their portfolios: the replacement of inefficient passive beta allocations with synthetic exposures that precisely replicate market risk with less capital. The freed-up resources can be allocated elsewhere to maintain liquidity and generate higher levels of excess return.

This type of strategy, known as capital-efficient investing, involves the use of liquid derivatives and modest leverage to achieve levels of return that would otherwise be unreachable without deploying riskier, more concentrated, and more illiquid asset allocations. It does not preclude the use of higher risk assets, nor does it preclude taking advantage of illiquidity. Rather, capital-efficient investment strategies complement these other investment approaches. When the natural limits on riskier asset classes—such as illiquidity and volatility—become binding, capital efficiency can help investors reach their strategic targets.

Natural limits on traditional return enhancers

Projected returns on major liquid market asset classes are currently at the low end of historical ranges: Equity multiples are high, suggesting lower returns going forward; bond yields and credit spreads are tight, limiting future returns, income and diversification. These market dynamics place a burden on asset allocators seeking to reach their long-term targets or stay ahead of inflation while maintaining a prudent level of risk (Exhibit 1). 

Investors face stark challenges in meeting their return targets due to high equity multiples, low bond yields and tight credit spreads

EXHIBIT 1: Combined earnings and coupon yield on a 60/40 portfolio

Source: Barclays, Bloomberg, FactSet, S&P Global, Thomson Reuters and J.P. Morgan Asset Management; data as of June 30, 2021. Guide to the Markets (U.S.)

Price-to-earnings is price divided by consensus analyst estimates of earnings per share for the next 12 months as provided by IBES since June 1996 and J.P. Morgan Asset Management for June 30, 2021. Valuation is calculated by summing 60% weight-to-earnings yield on stocks (inverse of forward P/E) and a 40% weight to the yield-to-worst on the Bloomberg Barclays US Aggregate Bond Index. Returns are based on a 60% weighting in the S&P 500 Total Return Index and a 40% weighting in the Bloomberg Barclays US Aggregate Total Return Index.

To some investors, dialing up the risk in their portfolios by raising their equity allocations and/or buying poorer-quality, higher yielding bonds, might seem like a suitable response to low potential returns, but caution is needed: The marginal increase in expected returns from moving from a traditional 60/40 portfolio of stocks and bonds to an 80/20 mix is negligible and typically results in a lower overall Sharpe ratio and a higher risk of a severe drawdown.

Although increasing exposure to alternative assets offers investors another potential solution, the amount is usually constrained by a need to maintain sufficient liquidity across the allocation. We generally support the broader use of alternatives, both in terms of the size of the allocation and the breadth of strategies within it, but most investors are reluctant to commit more than 20% of their available capital and would regard 30% as aggressive. Although increasing this exposure certainly helps boost portfolio performance (Exhibit 2), alternatives can only move the needle so much at these limited weightings.

Increasing exposure to equities or alternatives can positively impact overall portfolio returns, but may hamper liquidity

EXHIBIT 2: Comparative returns, volatility and Sharpe ratios for 60/40, 80/20 and 40/40/20 portfolios

Source: Bloomberg, J.P. Morgan Asset Management Multi-Asset Solutions; data as of December 31, 2019. Forecasts refer to our 2021 Long-Term Capital Market Assumptions (LTCMA) projections. Equity asset is U.S. large cap. Bond asset is U.S. Aggregate. Alternatives asset is defined as (0.5 * private equity) + (0.25 * U.S. Core real estate) + (0.25 * U.S. value-added real estate).

Leverage as the third dimension of return enhancement

Investors understand the ability to increase returns through leverage, as well as the additional risks that come with it—and some undoubtedly still view leverage as a malign force lurking in the shadows of private markets. But leverage is fundamental to all financial markets and investor portfolios: Fixed income applies leverage to an enterprise or asset, balancing a senior claim against lower fixed returns; stocks bear greater risk—and offer greater returns—from corporate use of balance sheet leverage. Virtually all types of alternative strategies, including real estate, infrastructure, private equity and hedge funds, use leverage. In a very real sense, leverage is intrinsic to investment even as it remains just below the surface of most portfolio allocations, visible only in the relative levels of return and volatility across asset classes.

Far less common is the direct use of leverage at the strategic asset allocation level to improve portfolio performance. Prudent investors are right to have concerns about the additional volatility that leverage can impart to a portfolio, but they should also consider the potential for the judicious use of leverage to enhance the efficiency of their scarce capital. With this goal in mind, we present a simple, actionable framework: first, for identifying opportunities across traditional liquid market allocations to introduce a modest level of leverage; second, for deploying capital in a variety of ways to improve risk-adjusted returns.

The myth of low cost passive investing

Passive beta may be cheap, but it is not necessarily low cost.

What does that mean? It is true that the price associated with hiring a manager to deliver passive exposure in most liquid markets is insignificant, and often close to zero, but the opportunity cost associated with obtaining passive beta through traditional securities—whether stocks or bonds—can be meaningful. An investor can easily make use of low cost index derivatives to deliver identical market exposure using only a fraction of the capital invested upfront as margin. Prudent risk management requires that a further portion be retained in highly liquid assets to serve as a buffer against future price movements, but a large portion of the capital is now available for investment elsewhere.

This approach presents an enormous opportunity to make more efficient use of resources that would otherwise remain trapped in passive portfolios of stocks or bonds. If the freed-up capital can be invested elsewhere to generate returns in excess of the cost of the derivative implementation, a capital-efficient investor will come out ahead. The nature and magnitude of potential excess returns will be driven by the type of investment chosen (Exhibit 3).

Leveraging passive portfolio allocations to stocks and bonds allows for the creation of capital-efficient synthetic beta exposures

EXHIBIT 3: Illustration of the progression from passive to capital-efficient implementation

Source: J.P. Morgan Asset Management.

Stepping-stones to capital-efficient portfolios

Step 1: Identify beta opportunities

The starting point for a capital-efficient investment program is the selection of a market beta that can be directly replicated at low cost using index derivatives. Most passive equity benchmarks would fall into this target zone, as would some passive government bond portfolios.

An example of asset allocations in a hypothetical portfolio that would be appropriate for potential reallocation

EXHIBIT 4: Allocations to passive equities and Treasuries offer the best options for beta replacement 

Graphic 1: Strategic asset allocation
Graphic 2: Sector allocations
Graphic 3: 40% of total portfolio has a capital-efficient alternative

Source: J.P. Morgan Asset Management; as of March 31, 2021.

Exhibit 4 illustrates that a common asset allocation may present multiple opportunities to implement capital-efficient strategies across U.S. equity, global equity and fixed income strategies. The scale of these combined opportunities can easily reach 30%–40% of portfolio assets, which allows for a meaningful increase in return potential.

Step 2: Select the index derivative vehicle

In Exhibit 4, our hypothetical investor has passive exposure to U.S. large cap equities (S&P 500), global equities (MSCI All Country World Index) and U.S. Treasuries. In each case, multiple options exist for implementing a capital-efficient program using exchange-traded derivatives (futures) and over-the-counter derivatives (total return swaps).

Using derivatives to replicate beta exposures may be incrementally more costly than passive asset allocations, but capital can be freed to generate returns elsewhere in the portfolio

EXHIBIT 5: Implementation considerations

Source: J.P. Morgan Asset Management

Although the costs of beta replication may be slightly higher than those of a basic passive mandate (Exhibit 5), the main benefit of the capital-efficient approach lies in its ability to generate higher returns elsewhere. The value of the total strategy will be illustrated in more detail below.

Step 3: Scale the liquidity portfolio, and select an appropriate investment vehicle

For any derivative chosen, investors will have to provide a minimum level of initial margin. Although 5% is a common rule, some variation exists depending on the type of instrument used. Industry standards suggest that additional liquidity well in excess of the minimum margin needs to be maintained to serve as a buffer against future price movements. Estimating the amount of liquidity needed is an exercise that involves both empirical data on volatility and some subjective judgment on the part of the risk manager (Exhibit 6). In general, we would err on the side of a conservative—meaning larger—backstop liquidity pool, even if this approach slightly reduces the economic benefits of the overall strategy. Better safe than sorry.

Building an effective risk buffer against future asset price movements requires careful analysis of the liquidity that might be required in the event of unexpected market volatility

EXHIBIT 6: Proposed ranges for liquidity requirements

Source: J.P. Morgan Asset Management

This preferred approach involves combining the derivative beta exposure and the full liquidity pool (both margin and additional backstop liquidity) in a single strategy with a single manager. This model has two important advantages: first, removing needless operational complexity and ensuring that margin cash flows are handled smoothly; second, allowing the remaining capital to be invested opportunistically without regard to liquidity management concerns. 

Step 4: Target a return-generating strategy

A wide range of possibilities exist for allocating the excess capital to generate attractive returns. We have chosen to highlight three potential options (among many possibilities) that illustrate different levels of alpha expectation and risk (Exhibit 7). In each case, we have made the conservative assumption that 50% of the notional derivative exposure will be held back in a liquid short-term fixed income strategy, leaving the remaining 50% available for investment elsewhere. 

• The first option, with the most modest risk and return benefits, would allocate the excess capital to an active, unconstrained fixed income strategy. This approach should generate returns in excess of the funding costs of the derivative and have low correlations to most betas.
  
  
• The second option, with moderately higher returns but some illiquidity, would invest the excess capital in a hedge fund portfolio to generate higher levels of uncorrelated alpha without directional market exposure.
  
  
• The third option would directly target higher levels of market risk
  exposure by investing the excess capital in a mix of public market active strategies that mirrors the overall strategic asset allocation. Effectively, this approach would increase exposure to the public markets and allow for higher potential alpha relative to the baseline portfolio.

Three potential options for investing excess capital can be modeled to demonstrate different levels of alpha expectation and risk

EXHIBIT 7: Risk-return metrics for baseline portfolio vs. capital-efficient investing options 1, 2 and 3 

Source: J.P. Morgan Asset Management, 2021 Long-Term Capital Market Assumptions

Prudent leverage is a powerful tool

Investors have long been willing to allocate away from traditional strategies toward alternative asset classes that deploy leverage to generate higher returns. Similarly, investors have also been willing to give managers the flexibility to use derivatives inside actively managed portfolios as an alternative to traditional securities. 

Now is a good time for more investors to take hold of these powerful tools and structure capital-efficient asset allocations that allow for modest leverage via index derivatives. The opportunity cost of traditional passive investments greatly outweighs the minimal cost savings they provide. The operational complexity of capital-efficient investing, while slightly greater than simply hiring a passive manager, is more than justified by the potential to generate higher risk-adjusted returns. Overall, the ability to add return potential in a low return world is simply too compelling to ignore.