This is Brandon Hall, Research Analyst here at J.P. Morgan Asset Management and I'm excited to walk you through the themes from the 23rd 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.  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 the guide, please let us know. 

Before looking at specific sectors, let’s get started with three basic questions: First, why should investors 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, is manager selection important in the alternatives space?  [SE(U1]

Onto our first question: Why alternatives? Many investors have an allocation to alternatives, but others have neglected them altogether in favor of a traditional 60/40 portfolio – that is 60% in U.S. stocks and 40% in U.S. bonds. While the 60/40 has provided strong returns for decades, future performance may be challenged by higher valuations, less diversification and diminishing portfolio yields. The first three pages of our guide address each of these headwinds.

On page 4 , we illustrate the elevated valuation issue by looking at a concept we call the “earnings/coupon yield” of a 60/40 portfolio.  This is constructed by adding the forward earnings yield on the S&P500 multiplied by 0.6 to the yield to worst on the Bloomberg U.S. aggregate bond index multiplied by 0.4.  The chart on the left shows that the 60/40 portfolio has become progressively more expensive over time and, as we show on the right, higher starting valuations have consistently pointed to lower long-term returns.[SE(U2]

Turning to page 5, we address the idea that when stocks zig, bonds are supposed to zag, thereby providing diversification to portfolios. This negative correlation worked well from 2000 to roughly 2021, when growth, not inflation, was the prevailing concern. However, it's important to note that in the 1970s, 1980s and 1990s, when inflation uncertainty was elevated, 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.  [SE(U3] In short, while bonds may be a great diversifier for growth shocks, they are less effective in diversifying against inflation shocks.

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 each of these issues.  However, the alternative asset you should employ depends on the particular portfolio shortcoming you are trying to solve[SE(U4] .  Page 8  highlights each of the different roles alternatives can play in a portfolio.  If income is your goal, you might want to consider private credit or real assets, like infrastructure. For total return, you could look at 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.[SE(U5]

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 25th and 75th percentile managers in areas such as non-core real estate, private equity and hedge funds.[SE(U6]

Now for a deeper dive into specific asset classes. Turning to page 18, we can see that real estate has a long history of providing investors with steady income across economic cycles. Over the past year or so, however, commercial real estate has grabbed headlines after an underwhelming recovery post COVID and a sharp re-pricing in valuations. [SE(U7]

Nevertheless, on page 23 we look underneath the hood to show there are opportunities in commercial real estate. While vacancy rates are high and rising in the office space, they are at much more manageable levels in the industrial and residential sectors. Indeed, net absorption, the difference between the square footage that is leased and the square footage that is vacant, ticked up in the second quarter for both industrial and residential properties. [SE(U8]

Similarly, on the right-hand side of page 35, we can see that delinquencies in office have sharply increased, but they are well below historical averages in industrial and multifamily. Most property types experienced a slight uptick in delinquencies over the past few quarters as they have faced a looming wall of debt maturities in 2024. Still, fundamentals in sectors outside of office remain intact, and the recent re-pricing has created opportunities for managers with liquidity to access quality assets at attractive valuations.[SE(U9]

Turning to infrastructure, page 38 breaks down where dollars invested into the space are being spent. We are particularly excited about the opportunities in this asset class as secular growth trends like the energy, AI and re-shoring transitions should significantly increase the amount of these investments over the next decade. The chart on the left shows average annual global infrastructure needs by type. As you can see, power is by far the largest at $1.1 trillion with Roads coming in at a close second. Nevertheless, an astounding $3.6 trillion in global infrastructure spend is needed to maintain and upgrade our current infrastructure.[SE(U10]

We added page 43 to the guide this quarter to further dive into this theme. Rising temperatures (as highlighted in page 41), increased data center usage related to AI and lower carbon solutions like electric vehicles are all new sources of demand that will require higher output from U.S. energy providers. Moving forward, upgrading and expanding our energy infrastructure will require tremendous investment, creating plenty of opportunities to deploy capital.[SE(U11]

Let’s move onto private markets. 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 49, 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. The left hand side shows this effect may be particularly pronounced in the Technology sector.  [SE(U12]

That being said, private equity is experiencing its own pressures.  As we show on page 56, 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 have remained elevated, even in a period of higher interest rates. [SE(U13]  This could be contributing to the sluggish private equity exit activity shown and, as shown on page 58, has led to a ramp-up in volume in private secondary markets as limited partners try to redeem cash from their investments.  Until exit activity improves, secondaries can provide investors with available liquidity exposure to seasoned assets at discounted valuations.[SE(U14]

Private credit has also been top of mind for investors, and rightfully so. As shown on slide 69, private credit lenders have played a larger role in LBO financing in the post pandemic era as banks implemented more strict lending standards. However, defaults in the asset class have accelerated in recent quarters while amend and extend activity remains elevated, warranting a focus on quality in the sector.[SE(U15]

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 81.  However, it must be stressed, as we show on page 75, that there is a huge dispersion in performance across hedge fund managers.  [SE(U16]

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 in the manner best suited for your client. Thank you for listening. If you have any questions or would like to learn more about our Guide to Alternatives visit our website at jpmorgan.com/GTA