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Investing

Three reasons to invest in alternatives now


Even before the COVID-19 pandemic, investors already were grappling with a “new normal” defined by historically low yields, the rise of passive index funds and slower economic growth.

It has made for a challenging environment that we expect will persist for years to come: Core bonds no longer offer the same degree of protection and income that they once did. Alpha opportunities are harder to find. Return expectations are lower across the board.

Bottom line: a “traditional” mix of stocks and bonds may no longer offer the same risk and reward profile it once did. 

For some investors, that may not be an issue if they can stay on track towards reaching their goals. But for those who need or want higher returns, or different sources of portfolio protection and diversification, it’s time to consider expanding the toolkit to include alternative investments.

We believe alternatives can be a compelling complement to a typical portfolio of stocks and bonds. But how exactly you might add alternatives depends on what you want to accomplish.

 

Searching for income in a world starved for yield?

Yields across the fixed income spectrum have been the collateral damage as central bankers around the world battled the fallout from the COVID-19 and Global Financial crises. Our 2021 Long-Term Capital Market Assumptions suggest that, over the next decade, total returns in U.S. investment-grade bonds could average only 2.5% a year; high-yield fixed income may only produce 4.8% per year.

Little surprise, then, that investors in search of premium income generation are increasingly looking to private credit and direct lending. These spaces can offer enhanced returns thanks to their ability to lend to under-tapped borrowers, especially those in the middle market space. In 2020, only 1.8% of public high-yield bond issuance captured deal sizes of less than $300 million. Many smaller companies seeking capital increasingly turn to private sources for capital and find the added benefit of less onerous regulatory burdens. Investors in private credit funds also reap benefits: wider spreads than are available from publicly traded fixed income as well as more attractive controls and documentation standards.

As another option, hedge funds that invest in leveraged loans may offer investors sources of income at relatively attractive yield levels. Such loans are made to non-investment grade companies, tend to be secured by specific assets, and sit higher in the capital stack than unsecured debt and equities. They offer a potential for yield greater than that of investment grade bonds but involve greater risk—which is part of why we prefer taking on exposure via seasoned active managers familiar with the space.

 

Seeking to generate above-market rates of return?

Expecting lower returns across the board leads many to ask: How do I find opportunities that can outperform the market and serve as an engine of growth in my portfolio?

One way is to identify the next great innovator or disruptor—and get early access to them through private investments.

For example, it’s projected that, by the end of 2022, 45% of repetitive work tasks will be automated or augmented by artificial intelligence (AI) and robotics, while 65% of global GDP will be digitalized1. By 2025, there could be upwards of 100,000 software and services companies2- and many of them are likely to be private.  Therefore, investing in many of the companies advancing this technological disruption requires access via private markets.

An investor also might consider infrastructure investments, which are classically associated with predictable cash flows, stable demand and monopolistic industries. Current estimates suggest there’s a $15 trillion gap between global infrastructure needs and projected investment during the next 20 years, creating a massive opportunity.

It’s important to note that “infrastructure” no longer means just building bridges, roads and the like. Today, it also means modernizing the economy. This opportunity set has expanded to include infrastructure that enables megatrends like digital transformation (e.g., building out 5G networks) and sustainability (e.g., expanding production of clean energy).

We’re also excited by opportunities in the next generation of real estate, where we see potential for capital appreciation with the additional kickers of income generation, diversification and a degree of inflation protection. What constitutes “next gen” real estate? Think, for example, of storage facilities for e-commerce. E-commerce sales jumped from roughly 17% to 22% of total retail sales during the pandemic, and require 3x more warehouse space versus traditional retailers. Or, consider affordable and manufactured housing. Here, we see pent-up demand as 52% of people aged 18-29 lived with their parents during the pandemic. Also keep in mind office space for the life sciences sector in which working from home is a non-starter given the need for laboratories and the like.

 

Looking to protect capital with defensive allocations or diversified return streams?

On average, hedge funds manage to participate more on the upside and less on the downside than run- of-the-mill stocks and bonds. Said another way: portfolios with hedge funds may “zig” when the market “zags,” helping to provide more consistent returns in different market environments.

Take, for example, what we saw in the first quarter of 2020 when the COVID-19 crisis began. As global stock markets experienced their fastest decline into a bear market on record, many long/short equity and global macro hedge funds were able to post positive returns—or at least minimize the downside. That was by design: Such managers aim to take advantage of market dispersion and elevated volatility, and offer portfolio exposures that are often uncorrelated with the broad market.

Similarly, even in periods of market stress, private investments tend to generate positive annualized returns over a multi-year time horizon. From 1995 through 2019, the worst five-year annualized performance for global equities was -5.7%. What happened to developed market buyout and private credit funds during the same time period? They generated 2.7% and 5.8%, respectively.

In the context of an overall portfolio allocation, there’s power in having varied sources of return. That includes having exposure not only to a variety of sectors and geographies, but also to both public and private markets.

 

Lowest five-year annualized performance

Source: Hamilton Lane Data, Cobalt, Bloomberg Financial L.P. As of December 31, 2020.

 

What are your goals?

Alternative investments such hedge funds, private equity and real assets can have tremendous benefits, but also come with tradeoffs. For example, investors in private equity and real estate sacrifice liquidity for the potential of returns that are higher than what is offered by public markets. Hedge funds often charge higher fees than their mutual fund and exchange-traded fund (ETF) counterparts, but they also tend to produce more consistent alpha. And not all managers are created equal; robust due diligence is crucial to ensure that these tradeoffs are worthwhile.

At J.P. Morgan, we employ our global and institutional resources to build a high-quality platform of alternative investment opportunities with both depth and breadth. That’s part of the reason why our clients have committed more than $100 billion dollars across hedge funds, private equity, private credit, and real assets over the past 20 years. Speak with your J.P. Morgan team to learn more about our platform, the latest opportunities and how alternative Investments may fit in your financial plan.

To learn more about Alternative opportunities, view our pipeline here.

 

1. IDC FutureScape: Worldwide IT Industry 2021 Predictions. October 2020. https://www.idc.com/getdoc.jsp?containerId=US46942020
2. Gartner Research. May 2019. 

 

 

 

 

IMPORTANT INFORMATION

Key risks:

  • Investments in alternative investment strategies is speculative, often involves a greater degree of risk than traditional investments including limited liquidity and limited transparency, among other factors and should only be considered by sophisticated investors with the financial capability to accept the loss of all or part of the assets devoted to such strategies.
  • Real estate, hedge funds, and other private investments may not be suitable for all individual investors, may present significant risks, and may be sold or redeemed at more or less than the original amount invested.
  • Private investments are offered only by offering memoranda, which more fully describe the possible risks.
  • There are no assurances that the stated investment objectives of any investment product will be met.
  • While investments in private equity funds provide potential for attractive returns, access to opportunities not available in the public markets and diversification, they also present significant risks including illiquidity, long-term time horizons, loss of capital and significant execution and operating risks that are not typically present in public equity markets.
  • Private equity funds typically have a 10-15 year term and will begin to monetize investments after holding them for 4-5 years.
  • Hedge funds (or funds of hedge funds) often engage in leveraging and other speculative investment practices that may increase the risk of investment loss; can be highly illiquid; are not required to provide periodic pricing or valuation information to investors; may involve complex tax structures and delays in distributing important tax information; are not subject to the same regulatory requirements as mutual funds; and often charge high fees.
  • Further, any number of conflicts of interest may exist in the context of the management and/or operation of any hedge fund.
  • Our investment management research incorporates our proprietary projections of the returns and volatility of each asset class over the long term, as well as estimates of the correlations among asset classes. Clearly, financial firms cannot predict how markets will perform in the future. But we do believe that by analyzing current economic and market conditions and historical market trends, and then, most critically, making projections of future economic growth, inflation, and real yields for each country, we can estimate the long-term performance for an entire asset class, given current and our estimated equilibrium levels. The “equilibrium” level shows the average or central tendency of a market or macroeconomic variable such as yield or credit spread that is expected to prevail over the long-term, because the level represents the value inherent in a given market. The return assumptions are based on our proprietary process of using a building block approach for each of the asset classes. For instance, the building blocks for equity consist of our projections on inflation, real earnings growth, dividend yield and the impact of valuations. The building blocks for fixed income consist of our projections for future yields and the change in bond prices. The estimates for alternatives are driven by our historical analysis and judgment about the relationship to public markets. It is possible – indeed, probable – that actual returns will vary considerably from this expectation, even for a number of years. But we believe that market returns will always at some point return to the equilibrium trend. We further believe that these kinds of forward-looking assessments are far more accurate than historical trends in deciding what asset class performance will be, and how best to determine an optimal asset mix.
  • In reviewing this material, please understand that all references to expected return are not promises, or even estimates, of actual returns one may achieve. The assumptions are not based on specific products and do not reflect fees, such as investment management fees, oversight fees, transaction costs or other expenses that could reduce return. They simply show what the long-term return should be, according to our best estimates of current and equilibrium conditions. Also note that actual performance may be affected by the expertise of the person who actually manages these investments, both in picking individual securities and possibly adjusting the mix periodically to take advantage of asset class undervaluations and overvaluations caused by market trends.
  • For the purpose of this analysis volatility is defined as a statistical measure of the dispersion of return for a given allocation and is measured as the standard deviation of the allocation’s arithmetic return. The Sharpe ratio is a return/risk measure, where the return (the numerator) is defined as the incremental annual return of an investment over the risk free rate. Risk (the denominator) is defined as the standard deviation (volatility) of the allocation’s return less the risk free rate. The risk free rate utilized is J.P. Morgan’s long-term assumption for Cash. Correlation is a statistical measure of the degree to which the movements of two variables, in this case asset class returns, are related. Correlation can range from -1 to 1 with 1 indicating that the returns of two assets move directionally in concert with one another, i.e. they behave in the same way during the same time. A correlation of 0 indicates that the returns move independently of each other and -1 indicates that they move in the opposite direction.

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