Alternative route to portfolio diversification

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I attended a meeting of the JPMorgan Retirement Plan that highlighted an interesting trend in the institutional investments world – differing approaches to alternative investments. In preparation for the meeting, I found that traditional state and corporate pension plans have only allocated about 10 per cent of their assets to alternative investments. But strikingly, a survey of 247 of the biggest endowments and foundations in the US reveals an allocation of 21 per cent to alternatives, with the largest 30 having an allocation of about 35 per cent.

The differences probably relate to the more entrepreneurial approach of endowments, less regulation and oversight, less adherence to liability matching and the fact that many defined benefit plans have finite lives and hence, liquidity constraints.

This begs the question: what is the right alternative investment allocation for wealthy clients? Our model portfolios are in the middle. We generally recommend an allocation of 20-25 per cent to alternative investments. Here we review some of the constraints that contrast with institutional investors.

Among the greatest proponents of alternative investments are the largest and most sophisticated endowments. David Swensen, Yale University’s chief investment officer, is a champion of the idea, and with 16 per cent annualised returns over the past two decades, his message is gaining increasing acceptance.

Given our outlook for single-digit equity market returns and increasing volatility, we agree that an absolute return focus should play a greater role in our portfolio construction. However, it is important to consider some of the significant differences between our clients and these endowments.

Mr Swensen has written extensively on the topic of portfolio construction as it pertains to institutional investors and retail investors but with little focus on wealthy clients per se.

For institutional clients, he recommends complementing stock and bond allocations with heavy investments in alternatives such as hedge funds, private equity, real estate and timber. His strategy has resulted in sustained returns through a variety of market conditions. But keep in mind that the Yale endowment has a whopping 65 per cent allocation to alternative investments, with only a third of the portfolio allocated to traditional asset classes.

In his recent book for individual retail investors, he paints a different picture. Why doesn’t Mr Swensen recommend the same approach for the individual investor?

A number of asset classes are simply not available to individuals. The amount of capital at a retail investor’s disposal does not readily allow for investment in private equity and most hedge funds. Individuals also face much larger headwinds from transaction costs and management fees.

Also, given the increasing importance of manager selection in alternative asset classes, individuals typically do not have the time or resources to identify the best managers.

Mr Swensen argues that individual investors should therefore pursue a more limited set of traditional investments. In lieu of alternative investments, he advocates that individuals build portfolios of stocks, government bonds, inflation protection and real estate investment trusts.

What about wealthy clients?

Our clients tend to resemble institutional investors from the standpoints of size and sophistication. As a result, does a fully fledged Swensen approach make sense for
our portfolios?
■ The Swensen approach requires a significant liquidity sacrifice. Many alternative investments have lock-ups of three to 10 years. Wealthy clients might be faced with an exogenous event requiring liquidity, or they might opt to change gears with investments. Either one makes a 50 per cent-plus allocation to alternatives problematic.
■ Large endowments tend to benefit from quasi-perpetual grants and donations on a yearly basis, at times equalling their spending needs. As a result, they can take more risk on their investments.
■ Endowments do not face the same tax hurdles as private clients. Many alternative investments generate either ordinary income, which is taxed at high rates in many jurisdictions, or a lot of short-term gains. Tax-exempt investors can capture the entire return, while taxable investors cannot.
■ Certain asset classes, such as timber, are owned by endowments in perpetuity, relying on interim appraisals to determine what these assets are worth. Not only does this require a leap of faith regarding the returns but it also tends to understate the volatility of these investments. Most private clients require a visible
exit strategy.
■ Endowments do not die and therefore have no estate tax issues to consider. As a result, they never risk having to monetise an illiquid or mispriced asset during a difficult business cycle.

During the past five years, alternative investments have been among the best performers in the portfolios we manage. Recently, income-based real estate, merger arbitrage and convertible arbitrage, and market-neutral hedge funds have been strong contributors.

So we have crossed the Rubicon into establishing a sizeable portfolio allocation for them. But it is clear differences between wealthy families and perpetual endowments have to be taken into account, particularly with alternative asset classes and managers with not much more than a decade of history.

Michael Cembalest is chief investment officer for JPMorgan’s private clients

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