“We’ve had a crash course in how different alternatives work over the course of the year so far,” said David Lebovitz, Executive Director and Global Market Strategist at J.P. Morgan Asset Management, adding it’s been notable that plan sponsors have seen the benefit of simply having diversifying alternatives in their portfolios during the downturn earlier this year. “Now, investors expect they will continue to benefit as the economy comes back online for some of those return enhancers like private equity. So, even over the course of the past 7 to 8 months, we’ve seen empirically the way that different alternatives behave, and it’s almost been a proof statement, if you will, in the value that alternatives can add over longer periods of time,” said Lebovitz, speaking at Pensions & Investments’ DCW Fall Series virtual conference.
TAKE AN OUTCOME-ORIENTED APPROACH TO ALTERNATIVES
Allocation to alternatives is a two-step process, he said. “The first question we ask is, ‘What are you trying to achieve?’ Are you allocating to this space as you want to enhance the income your portfolio generates, further diversify equity risk, or enhance your overall rate of return?’ ” The second decision that clients need to make is to choose the right vehicle and the right manager, Lebovitz noted, at the session titled, ‘DOL Encourages Thoughtful Use of Alts in DC’ where panelists discussed the impact of the recent DOL letter clarifying that diversified funds with private equity may be added as DC investment options.
Looking at data on public and private market correlations across 12 global traditional and alternative assets from 2008 to 2020, underscores the importance of taking an outcome-oriented approach to alternatives, he said. “The reality is that different types of alternatives do very different things. If you’re trying to achieve diversification benefits relative to stocks and bonds, you’re far better suited to core real assets, like real estate, infrastructure, and transportation. If you’re trying to enhance your overall rate of return, then it makes sense to look at other parts of the alternative asset universe such as private credit, direct lending and private equity, and certain types of hedge fund strategies.”
“We’ve been saying for the better part of 10 years that the role the active manager can play in the portfolio is the ability to successfully generate alpha,” Lebovitz said. He considers 10-year data on the dispersion of returns between the top and bottom quartile managers in each asset class. “What you see is that, despite the fact that people get upset over their large-cap equity manager or core fixed income manager underperforming, the dispersion of returns in traditional stocks and bonds is actually fairly narrow versus what we see for managers of the alternative asset classes,” he said. The dispersion of returns is far wider for private equity (18.7% for top performing versus -0.4% for bottom performing), venture capital (19.7% versus -3.3%), and hedge funds (11.7% versus -1.6%), he said. “As we look at alternative asset classes broadly, we can recognize that the difference between winners and losers is far greater than in traditional public markets. So allocating to alternatives, while maintaining a fiduciary mindset, is a two-step process that can provide access to the alpha that managers are able to generate within these less liquid, less efficient markets,” he added.
While the recent DOL clarification is directionally very helpful for DC plan sponsors to consider private equity as part of diversified funds, there continue to be concerns around fees and illiquidity, Lebovitz said. “Part of what people tend to overlook is if you invest in a private equity vehicle, it’s a multi-year lockup. That allows the general partner to purchase companies that improve operational efficiencies—and we believe private equity is much more about operational improvement than it is about financial engineering—and since your capital is locked up for that period of time, you are able to get that higher rate of return versus the public markets,” he said. As DC plan participants move in and out of the plan as they retire and sponsors need to maintain liquidity to that end, that multi-year lockup can be a concern, he noted.
“But generally, what we’ve seen with DB clients for some time and we’re seeing it more on the DC side, is a recognition that public asset returns will be under pressure going forward,” Lebovitz said. J.P. Morgan’s recently released long-term capital market assumptions, with the large-cap U.S. equities outlook as just one example, are not very robust and insufficient to hit the return targets that plans have in place. This underscores the need to incorporate these less liquid assets that are able to generate more robust rates of return. Many DC plans have taken first step with real estate in target-date funds and he expects private equity as the logical next step.
“As we’ve seen alternatives becoming more accessible to retail investors, a lot of the challenges that we’re discussing here today have come to the forefront of the conversation and we’ve begun to see creative ways to resolve issues like lines of credit to meet redemptions, using the interval fund structure, and so on,” Lebovitz said. He believes that with a bit more clarity from regulators on their expectations of how DC plans should move forward on, coupled with the innovations across the alternative investment universe, alternatives will grow their share of DC plans in the coming years.
The valuation of alternatives has also been a concern, with investors having to sometimes wait for months to see where an asset was marked in the prior quarter. “What we’re finding is that in this world of big data, the valuation challenge has forced us to look at alternative data sets and think of other ways to mark to market using a variety of sources rather than relying just on the bottom-up audit,” Lebovitz said. Asset managers are increasingly nimble and comfortable using methods that have not been used traditionally, and he expects continued progress in addressing the issues and shortfalls that alternatives have presented in prior years, he added.
“Regardless of what you feel about alternatives, the bottom line is that a combination of quantitative easing and the massive liquidity injections has pulled forward a great deal of return in the public equity markets and, simultaneously, squashed any meaningful income from across the bond markets. So the use of alternatives in retirement plans going forward is going to be a necessary condition for investment success.” Now that some ground rules have begun to be laid, investors can focus on embracing alternatives while maintaining their fiduciary standard of prudently helping people achieve their retirement goals, he said, adding “This current momentum is exciting, from an asset manager’s standpoint, to be able to offer a wider array of products while keeping that fiduciary mindset.”
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