Transcription
Hello and welcome to the very first episode of Alternative Realities. I'm David Kelly, Chief Global Strategist here at JP Morgan Asset Management, and this is our podcast focused exclusively on alternative investments. In these episodes, we hope to shed some light on the rapidly growing and increasingly important world of alternative investments. Topics will range from the principles of alternative investing to deep dives into specific asset classes.
Today, we're going to start with the basics. What's Ws Wids and who Els? The classic 60/40 stock bond allocation has long been a stall of portfolio strategy. Currently, however, higher inflation has made the protection typically offered by the negative correlation between stocks and bonds less certain. Equity risk Premia are low, and interest rate volatility is high. On top of all that, public markets are becoming increasingly efficient, using opportunities for excess return. As a result, investors are turning to Alters to ensure portfolios can still meet their long-term goals. Each alternative asset class has distinct characteristics and consequently, distinct role in portfolios. So, I've invited my colleague Sean Kazam here today to help us walk through the different ways clients are using alternatives to enhance the risk War profile of the portfolios. Sea is responsible for the growth strategy, sales, and distribution of private market alternative Investments offered by our firm. But Sean, welcome to Alternative Realities.
Thank you, David. Thanks for having me. So, first, let's just talk about why alternatives are getting so increasingly popular here. Uh, their use in portfolio construction used to be the exception, but now we're seeing more and more investors, both institutional investors and individual investors, at an allocation. Why do you think that is?
Yeah, it's interesting, you know. I think it has two kind of factors that are influencing that outcome. You know, number one, I think investors are finding it increasingly more challenging to achieve their goals through the use of public markets on their own. Um, and I'll give you, you know, I'll give you a few examples. If you look at the number of public companies, uh, out there today, they have been steadily coming down. Um, and today, uh, they represent about 15% of all companies P certain size in the US. And so, if you were just going to be investing in public equities, you would be leaving off to the side, outside of your investable universe, 85% of the companies that are out there. So, very limiting, somewhat, um, if you're just looking at public equities.
Then, if you look at the role that investors usually rely on bonds for, one of those things, aside from income, is to provide a portfolio stabilizer, protection. Now, in most cases, stock bond correlations are low. In some cases, negative. But we know what happens when there are market pressures, you see those correlations spike up to one. And so, bonds don't always provide the level of protection that investors expect from them when they need the most. And so, you kind of think about, uh, you know, limiting yourselves only to public markets to achieve goals that you have is becoming increasingly more difficult.
Now, if you look at an allocation to Alternatives, whether it's into a 60/40, 70/30, um, any allocation to Alternative not just improves your return, but it also reduces your risk. So, for those reasons, I think they've become more wanted by investors. When you look at what has been a challenge in the past has been to how to access them. And usually, alternatives have been reserved for the wealthiest individuals, the most sophisticated institutions. And over time, there have been innovations in the market that have allowed some of those barriers to come down. You no longer need to have $5 million or more in assets. You no longer need to foot minimums of $10 million. You can get away with a $1099 instead of a K1. So, alternative structures have become more accessible. And I think the Confluence of those two factors has been, uh, the rationale for the growth that you're seeing today.
Okay. And, you know, I think Alternatives do, I mean, there's a lot of different Alternatives, and they can play different roles. Can you talk a little bit about the many different ways the clients use Alternatives, uh, to improve portfolio outcomes?
Yeah, so that's an interesting one to me because historically, when you, when I've spoken with advisers, they always talk about using alternatives to enhance return. It's about alpha, alpha, alpha. H. And the reality is, is that alternatives can be used in many different ways. We often like to say, alternatives provide aid to portfolios: Aid, Alpha, Income, and Diversification. And so, it's really important that advisers think about first, what they are trying to achieve from that alternative, uh, allocation to then figure out what alternatives they should use to either achieve that Alpha, income, or diversification in the portfolio. Um.
So, it seems like there is a growing swath of Alternatives, many, many different kinds of Alternatives, and of course, uh, many, uh, companies now, uh, offer them. Um, but how should investors think about portfolio construction with so many options available? I mean, is there a time when public markets are actually the right answer?
Yeah, look, I mean, I think it, it really depends. I mean, let's think, let's go back to that construct that we talked about, uh, with Alpha, Income, and Diversification. When you're thinking about Alpha, um, you look at areas of private Equity, um, mainly in the small midmarket, and you can see, uh, spreads over public higher than five or 600 basis points in many cases. Um, you look at income, um, where today you can receive cash yields from private credit of up to 10%, and in some cases, real estate allows you to get some tax advantage in the cash yields that you receive. So, there's a role for Alternatives, um, in the income space.
And then finally, with diversification, I always like to talk about private infrastructure here, uh, offering load and negative correlation there to both bonds and equities. So, they're providing a benefit to your overall portfolio. You know, when you think about, um, Alternatives from a, a public market perspective, um, I think it's really important to think about the diversification benefits that you're getting, not just from equities and bonds, but also from other alternative asset classes. And I'll give you an example. If you look at the correlations on a pairwise basis between hedge funds and real estate, they're low to negative. So, when you think about, to answer your question on how to allocate to Alternatives, it's not just about choosing any alternative asset class, but the broader your allocation to the various alternative asset classes, the better your diversification benefits overall. We call that a double diversification, uh, benefit.
And then, in terms of thinking about how to allocate, um, we often think about it in a core satellite approach, David. And based on our research, in the core, you want to have alternative asset classes that provide more forecastable returns, where more of your returns are coming from income, you're using less leverage, there's less dispersion of outcomes. And we often say, based on our research, and this is obviously dependent on specific constraints that clients may have, but on average, around 60 to 70% of your allocation should be in those core types of asset classes: core real estate, infrastructure, private credit. And then within your satellites is where you want to layer on some return-enhancing Alternatives like Venture Capital, like private equity. And, and, and put all those two together, that's where you see kind of the best, best risk-adjusted returns from our research.
And so, if we're going to make this alloc, and I think that, I think you make a very strong argument for why investors really need to think about an allocation to Alternatives, but where's the money going to come from? How would you fund this, the rest of the portfolio?
Yeah, so that, that I actually think, um, is, is one that's easier to tackle. I often say, if you figure out the role that you want that particular asset class to play in your portfolio, um, you should be funding that from the same, uh, public Equity, uh, or public market asset class. So, let me give you an example. Um, private Equity is considered a return enhancer. You typically see that funded from public equities. Private credit, on the other hand, which is an income producer, you often see that funded from public credit. Um, the case of real estate is an interesting one because it has both income and growth properties associated with it. And therefore, depending on what the desired outcome is, you may fund that from bonds, you may fund that from equities, or in some cases, from munis directly, because both contain some tax advantage to the, the, the distribution that you receive. Um. And so, you always want to be funding from the asset class that serves the same purpose on the public side.
All right. So, if you've decided where you're going to put the money, and you've decided where it's going to come from, does it matter then when you, when you're selecting a manager? Are all managers and Alternatives roughly the same?
You know, David, this is probably one of the most important things that a financial adviser can do for their clients, and that's manager selection. To answer your question directly, no. You see a lot more dispersion in private markets than you do on the public side. And I'll just throw some examples out there for you. Um, on the public side, you know, the average dispersion that you see across the top and bottom CTI managers is around 100 basis points. Um, for comparative purposes, uh, in private Equity, that dispersion between the top quartile and bottom quartile managers is over 20%. In Venture Cap, it's even greater than that. So, the risk of choosing the wrong manager is significantly greater in Alternatives than it is on the public market side, which makes manager selection and working with an experienced GP even more critical, and diversifying across multiple GPs to really diversify way as much as possible. That manager selection was, um, incredibly critical as well.
All right. So, when we're talking about risks, uh, if you've, if you've dealt with that, or if you, if you try to address that by by diversifying across managers, there are broader risks, though, alternatives. I mean, what sort of volatility could investors expect from private markets relative to public markets?
Yeah, I, I'm less concerned around the volatility in privates versus public, only because publics trade more frequently than privates do. You think about real estate, real estate has valued, um, many of these funds on a monthly basis, in some cases quarterly. So, you're naturally going to be smoothing out the returns over time. And so, that's why, you know, if you think about the S&P at around 15% annualized volatility, um, private Equity tends to be less than that, tends to be less than 10%. You think about, you know, bonds at around 5%, um, annualized volatility on the public side, and areas like infrastructure on the private side, less than 2% annualized volatility. So, a lot of that has to do with the fact that they're priced more infrequently. But in my view, you know, the bigger risk there on the private side are things like illiquidity. Um, there are things like the manager selection risk that we talked about just before. And there are things like political and regulatory, when you are owning a utility, or you're owning a large building or an airport, etcetera, you know, political and regulatory risk is real and needs to be managed.
Good, good point. But let's, let's just, one thing you mentioned there, liquidity. I mean, I think that's, that's one of the things that I hear about, a lot of people talk about is the problem of it is pretty illiquid as an investment. I mean, is that true, and what kind of risks do you think about that are sort of associated with that?
Yeah, I think, um, when, uh, advisors are performing suitability on their clients, this is one of the most paramount things that needs to be investigated. You know, historically, David, the closed-end fund structures that were used to deliver alternatives to, uh, investors were fully illiquid. So, you would, uh, commit some money, that money would be called over a period of three to five years, and you wouldn't see that money for upwards of 10 years coming back to you. Come back in drips and drabs, but your entire capital wouldn't be back for 10 to 15 years. What's happened now with some of the innovations in the vehicle structures that you've had are some of the vehicle structures now guarantee some forms of liquidity, think interval funds at about 5% per quarter. And others like tender offer funds or certain types of non-traded REITs or BDCs, um, they target a certain level of liquidity, namely 2% per month, 5% per quarter. However, they don't guarantee it. And, um, you know, we think it's incredibly important for, um, individual investors to understand that they should not expect to receive their capital back in the near term. Sure, with the advent of some of these new structures, there is now a possibility that you could receive your full capital back should you be applying for a redemption at a time when no one else is due to an idiosyncratic reason. But most of the time, investors tend to want their money back when the rest of the market is also wanting their money back. And in those circumstances, really, investors shouldn't expect to receive more than the targeted outcome, or nothing at all, over time. So, it's really important that investors have a long-term perspective with this allocation, as they think about, uh, liquidity needs.
Yeah, Chris, that makes sense. I mean, a lot of investors have very long-term goals, so having part of the portfolio, the stock will be realized for a long time, makes sense, as long as it's just part of the portfolio, right? Um, so, okay, well, last broad question. I mean, it's the Alternatives market is evolving a lot. How do you see it's evolving over the next few years?
So, I am really excited about the growth that we're seeing in the market today. Um, you know, coming back to the thing I told you at the beginning, alternatives really serve a purpose in portfolios today, and they're now more accessible. And I think that Confluence is going to continue to, um, grow this asset class significantly in the future. And to provide some numbers, um, you know, if you look at all the client assets, the hundreds of trillions of dollars of client assets that exist today that are held by individuals, sovereign wealth funds, pension funds, insurance companies, etcetera, um, individual investors make up 60% of those hundreds of trillions of client assets. So, a significant portion. Yet, their allocation on average today in the US to Alternatives is less than 5%, compared to a sovereign wealth fund, um, which could be upwards of 50%. Now, we wouldn't endeavor to believe that individuals should be owning 50% necessarily, unless they had very specific needs. But, you know, even if you think about going from four to five to six, each 1% growth, you know, generates trillions of dollars of flow into the alternative asset classes. And, um, you know, there's been some studies out there that have said it's about eight trillion that's expected to flow into this over the next eight years, which is really interesting. But also, really puts the onus upon managers, upon financial advisers, to focus on managers with experience managing in this asset class, focus on educating, uh, advisors as well as end investors as to what to expect from this asset class, and always focus on diversification, uh, broadly.
All right. Well, well, Sean, thank you for your insights today.
Thanks so much, David.
See you later on our next episode of Alternative Realities. I'll be joined by Ashme Mar OTA, the co-head of our Private Equity Group, to discuss the opportunities and challenges of the asset class. To all our viewers and listeners, thank you for tuning in to our very first episode. I'll see you soon for the second.
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