Alternatives Set To Play Larger Role In Investor Portfolios In Coming Decade
The traditional 60/40 investment portfolio model – 60% stocks, 40% bonds – has come under scrutiny in 2020 perhaps more closely than ever before due to the zero lower bound interest rate environment negating bond yields and because equities, particularly U.S. equities, are considered to be expensive by many measures.
The 2021 edition of JP Morgan’s Long-Term Capital Market Assumptions report was published recently, and the firm’s analysis reads miserably for disciples of the 60/40 model: a balanced portfolio with a 60% global public equity and 40% U.S. fixed income allocation is forecast to deliver only 4.2% in USD terms over the next 10-15 years with volatility of around 10%.
Pulkit Sharma, Head of Alternatives Investments Strategy & Solutions at J.P. Morgan Asset Management in New York, says that record policy intervention is a significant contributing factor to JPM’s outlook.
“Both ends long-only public equity and bonds are dramatically compressed looking out, which is very unusual for an early economic cycle. It’s not supposed to be this compressed right now. Both monetary and fiscal intervention is driving this compression,” he said.
Enter alternatives. JPM suggested last year that investors look beyond the traditional 60/40 approach, but this year’s report amplifies that view. Private equity in particular is set to outperform, with tailwinds supporting JPM’s position.
“If median manager PE is around 7.8% long-term capital markets return, and cap-weighted global equity is around 5.3%, then the delta of 250bps or 30% of 7.8% is long-term private market alpha,” said Sharma. “The Covid impact has been tangible in private markets. The dry powder currently on the side lines will find an increasingly profitable home on the back of increased digitisation, innovation, home services trends, and an increasingly global opportunity set. This aids alpha generation for private equity as an asset class.”
Equity hedge fund strategies have fallen out of favour in recent times, with eVestment suggesting that $64.07bn has been pulled from long/short equity hedge funds by investors in the past two years through October 2020. Sharma says that the recent tide could be about to turn, however, but regardless, the focus for investors looking at hedge funds should be both alpha and diversification.
“In the last few years, equity hedge fund returns have suffered because stock dispersion hasn’t been high enough, and macro factors have dominated fundamentals. The market has been driven by a small cohort of stocks and this has led to lower returns,” he said. “But rising volatility adds to the alpha story for hedge funds, we expect alpha to improve toward its long-term historical mean. Hedge funds broadly are hybrids that are supposed to deliver returns between equities and bonds over the long term. They are diversification tools which can offer downside protection and mitigate volatility. That’s a powerful combination to have in the context of a multi-asset portfolio.”
In a fixed income-oriented category, relative value hedge funds are set to deliver 3.6% long-term for a median manager; compared to JPMs outlook for U.S. aggregate bonds at 2.1%, that’s a significant outperformance, with their less than half the volatility of public equities.
A theme piece in the report titled “Alternatives: From Optional to Essential” highlights the importance of outcome-oriented allocation across and within alternatives. It illustrates how investors with different risk-return objectives can improve their total portfolio outcomes with an alternatives allocation that similarly matches their distinct overall objectives. Starting with three multi-asset portfolios with different equity/bond allocations: Conservative (40/60), Balanced (60/40) and Aggressive (80/20), in each portfolio 30% of capital is re-allocated from equities and bonds to a diversified, risk-return-appropriate alternatives set blending equity-like (private equity focus), fixed income-like (alternative credit focus) and hybrid (hedge funds and real assets focus) alternatives. In each case, the alternatives allocation improves the overall expected return and reduces portfolio volatility. For those with a more balanced approach (60/40), a 35/35/30 (with 30% in a risk appropriate alternatives allocation) moves the efficient frontier approximately 15% higher on return and lower on volatility, from around 4.6% return with 9.6% volatility to 5.2% returns with 8.2% volatility; aggressive investors (80/20) can improve returns by 100bps from 5.4% to 6.4% with a 60/10/30 equity-like tilted alts mix with a 12.4% volatility.
Adding alternatives to a multi-asset portfolio is not all roses, however. Hedge funds are a relatively more liquid alternative investment in the broader alternatives’ universe, but initial lockups of a year are common before redemptions are permitted, and manager dispersion can be as high as 200-300bps on average between top quartile and median managers. Allocating to private equity surrenders liquidity significantly, with a decade-long lockup the norm for these strategies. Furthermore, similar to hedge funds, the report shows that manager selection remains critical in private equity particularly, with significant historical dispersions amongst returns; the average return for a small private equity fund (those less than $1bn in size) in the top quartile come out at 19.2%, but just 2% for a bottom quartile fund. For mid-sized funds – those between $1bn and $5bn – it’s a similar story with 17.4% at the top end and 2.9% at the bottom end. Investors looking to allocate to private equity managers need to dig deep to understand where these managers are placed.
“For small and mid-size PE, the dispersion of returns is huge, so you need to look at whether they are on the right side of alpha trends – things like digitisation, disruption, changing consumer preferences, energy transition, ESG etc. Due diligence is critical, and can’t be underestimated,” said Sharma.
Different investor types have different objectives for their investment strategy, of course. Corporate pensions and insurance companies have liability or regulatory constraints so construct their investment assets accordingly, whereas a sovereign wealth fund likely would not have as stringent constraints. The overall message remains, however; that considering alternative investments as part of a multi-asset portfolio is becoming increasingly essential.
“Investors need to ask themselves what they are looking to solve for. Is it alpha and diversification? Is it diversification and income? That decision informs the allocations they would make to different types of alternative investment products,” said Sharma. “But what’s also important is the target return for the investor. Back in 2007/2008, we were predicting around a 7-8% long term return from a traditional 60/40 stock and bond portfolio, which was enough for many investors. But if you need a return like that to fund your objectives, and you’re getting around 4% or so from that same mix now, the gap can only be made up by alternatives and active management.”
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