Core Alternatives Deliver What Public Markets Cannot

In a challenging public market environment, there are alternative ways to improve returns without adding risk

The current challenges facing investors seeking to build portfolios capable of generating attractive returns with acceptable levels of risk may never have been greater. Low starting yields in core fixed income and lofty equity valuations, along with the prospect of rising inflation, will require investors to expand their portfolio construction toolkit. The traditional stock/bond portfolio mix that has worked effectively for the past 40 years needs to be reconsidered, and new allocation models deployed.

Among the most promising available opportunities are underutilized core and hybrid alternative asset classes. These offer returns in line with investors’ historical objectives along with lower volatility and appealing diversification characteristics. As a group, these investments can provide a permanent, strategic substitute to richly valued public market fixed income and equities.

Here we explore how a portfolio allocation of actively managed, high-quality, diversified, predominantly private market alternatives, or the ‘Core Foundation’ categories, can improve portfolio outcomes. We include scalable assets in which the majority of return is derived from long-dated, forecastable, and stable cash flows – thereby offering strong diversification and resilient return benefits 

Core Foundation Categories Could Play Central Role in Success
Core Foundation alternatives, or ‘core alts,’ cover a range of assets. Some alternatives are more fixed-income-like in nature, such as private market senior secured alternative credit, whereas others are a hybrid between fixed income and equity, such as private market core real assets, which can offer both steady income and capital appreciation over time. Finally, there are also low-volatility, equity-like liquid alternatives options. These categories also exhibit lower manager dispersion of returns vs. typical non-core categories.  

Relative to our expectations for public market assets, we believe that a core alternatives allocation delivers meaningful outperformance vs. both equities and fixed income over the forward horizon. An approximate performance premium of 200-300+ bps over public equities and 400-500+ bps over US fixed income seems achievable, with strong public equity diversification and much lower downside risk than equity. This is not magic, of course – there are some trade-offs, including less liquidity compared to public markets. However, our analysis suggests that most investors have sufficient exposure to liquid assets that a 10% or more move to core alternatives is easily manageable.

Adding Core Alternatives as a Substitute to Bonds, Stocks, or Both
A mere 10% allocation to core alts can materially improve portfolio outcomes (Fig. 1). This is the case whether looking to improve returns by re-risking from bonds to core alts, to de-risk by allocating from equities to core alts, or to take a balanced approach between the two. As an example, annual expected returns can increase by +0.5% when re-risking from bonds, while downside risk can be improved by 1.9% when de-risking from equities. Additionally, an allocation to core alts can complement traditional financial alternative categories, such as private equity and hedge funds, by diversifying the alternatives allocation in new directions, providing for more resilient long-term outcomes than these standalone alternatives.  

The Importance of Thoughtful Portfolio Construction within the Core Alts
The cross-asset correlations within the alternative investment universe result from fundamentally distinct return drivers across the underlying asset classes. The various components of a portfolio should be assembled so there is low correlation between each component, allowing investors to capture higher returns with less volatility than a more static allocation to the individual core alternative sleeves (Fig. 2).

Putting the Liquidity Trade-off in Context
One of the trade-offs of an allocation to core alts is the relative illiquidity compared to public market assets. While managing portfolio liquidity is critical for investors, there is such a thing as too much liquidity, particularly in a market environment where public assets are likely to produce unacceptably low returns. A 10% substitution of core alts for bonds and stocks described above is well within the illiquidity budget of most investors.

Further, when viewed on an illiquidity spectrum that includes the full range of private investments, core alts offer a hybrid liquidity profile with relatively short lock-ups and higher cash flows than are available in some areas of the private markets. Given that many investors will not require immediate use of the income stream, reinvesting income within core alts can generate equivalent net return multiples compared with less liquid strategies such as private equity (Fig. 3).

This makes core alts a compelling use of an investor’s illiquidity budget, as either a foundational alternatives allocation or a complement to long lock-up private market strategies. The return pattern resembles less of a J-curve and more of a ‘forward slash.’

The Closing Argument for Core Alternatives
Investor portfolios usually consist mostly of stocks and bonds, despite well-founded concerns that they will be unable to achieve levels of return and risk diversification consistent with historical experience. Against this backdrop, investors need solutions that can improve returns without adding risk. Core alts are an actionable solution that can deliver stable returns in excess of public markets, while also providing attractive downside risk protection along with resiliency to inflation and rising rates.

Core alts can offer a higher-returning substitute to fixed income and equities. A 10% allocation can move the needle on performance while maintaining prudent levels of liquidity. Relative to more opportunistic private investments, they have the potential to offer a compelling risk/return profile, improved downside risk, more equity diversification, and better liquidity.  

With its income stream reinvested, core alts stand on par with more aggressive alternative investments while retaining a more prudent risk profile. In a challenging public market environment, expanding exposure into private markets – in a thoughtfully designed, internally diversified program – is a powerful tool for investors.

About Pulkit Sharma
Pulkit Sharma, CFA, CAIA, Managing Director, is the Head of Alternatives Investment Strategy and Solutions (AISS) business, which is part of J.P. Morgan Asset Management’s global alternatives division. Pulkit is responsible for portfolio design and management of multi-alternatives investment solutions that span global real assets such as private real estate, infrastructure, transport, and alternative credit, private equity, liquid alternatives. In his role, he works with the firm’s investment, solutions, and research personnel and global investors such as insurance companies, sovereign wealth funds, pension plans, and wealth managers to build and manage customized private markets portfolio solutions to help deliver on investor objectives. Pulkit co-founded the private real assets portfolio strategy and solutions business for the firm’s institutional clients.  

About Jared Gross
Jared Gross, Managing Director, is the Head of Institutional Portfolio Strategy, responsible for providing insights and solutions to institutional clients, including corporate and public pensions, endowments, foundations, and healthcare institutions. Prior to joining J.P. Morgan in 2020, Gross spent more than a decade at Pacific Investment Management Company (PIMCO) where he was the Head of Institutional Business Development, and a member of PIMCO's investment solutions team.

Prior to this, Gross held roles at Lehman Brothers as Co-Head of Pension Strategy and Vice President in the Pension Solutions Group at Goldman Sachs. He also previously held positions as Special Advisor on investment policy at the Pension Benefit Guaranty Corporation (PBGC) and as Senior Advisor for financial markets and domestic finance at the US Department of the Treasury.