JPMorgan Chase & Co. is warning investors to beware of alternative asset strategies that use leverage in what is likely to remain a highly volatile market.
Volatility will stay elevated as the Federal Reserve reverses the unprecedented monetary policy put in place after the global financial crisis in 2008, according to a JPMorgan report expected to be released today. “It is naïve to think that quantitative tightening will not impact asset prices around the world — what goes up must eventually come down,” JPMorgan’s asset management group said in the global alternatives outlook report.
The firm recommends being overweight core alternative investments that use little to no leverage to produce returns because of concern about refinancing risks this late in the economic cycle. Investors willing to reach for yield in private equity should focus on managers who rely less on debt financing to produce returns, JPMorgan suggested.
“We’re much, much more cautious today on using leverage,” Anton Pil, a managing partner of J.P. Morgan Asset Management’s global alternatives group, said in a phone interview. “You do not want to use financial engineering today to get to your returns.”
Investors in alternative strategies — including private equity, private credit, real estate, real assets, and hedge funds — should be willing to accept lower returns instead of trying to use leverage to hit a performance benchmark, Pil said.
J.P. Morgan Asset Management typically suggests an alternatives portfolio that is 70 percent allocated to core investments such as real assets and private credit as well as “complements” like hedge funds, according to report. Investing the balance in riskier assets such as private equity and distressed credit can help increase gains.
Pil said he’s now leaning toward assets that are resilient in tumultuous markets. For example, real estate, infrastructure, and transportation can provide stable income and uncorrelated returns that tend to rise with inflation, according to the report.
While the firm sees investment opportunities in private credit, Pil worries about the rise of the covenant-light loans in the shadow banking market and questions whether fund managers would be willing to refinance debt when market sentiment sours. They have increasingly replaced banks as lenders in the middle market without being subject to the same regulatory scrutiny as Wall Street, creating concern surrounding their liquidity profiles.
“There’s a whole new school of lenders today that don’t have a long-term relationship with the people they lent money to,” Pil said. “It remains to be seen whether they have a permanent source of capital that can allow people to refinance.”
The overuse of leverage to produce returns is potentially risker today than it was five or 10 years ago because the Fed is removing liquidity from the market, according to Pil. Private credit funds borrowing against their portfolios add another layer of refinancing risk: “That, I would be even more cautious about,” he said.
JPMorgan’s asset management unit is preparing for a recession despite expecting the U.S. economy to continue growing this year. The group is seeking high-quality deals in private credit and opportunities to lend against real assets that it owns, such as buildings or ships, Pil said.
Private equity is an area of alternative investing where J.P. Morgan Asset Management is concerned about excessive risk-taking. After pouring record capital into the industry, institutional investors have grown concerned that buyout funds have overpaid for companies in highly-levered deals.
“As long as default rates stay low, none of this really matters,” said Pil. But as interest rates rise and debt becomes more expensive, a company’s credit profile can deteriorate, he explained, hurting its valuation.
J.P. Morgan Asset Management expects the Fed will hike at least once this year “then pause as U.S. growth softens amid waning fiscal stimulus,” according to the report. The U.S. economy will expand an average of 3 percent during the first half of 2019, the firm predicts.
As investors grow jittery in the aging bull market, hedge fund managers should find more opportunity to perform well, according to Pil. That would be a change of fortune for the industry.
Hedge funds have generally struggled to deliver alpha over the past three to five years, he said, and they will probably continue to underperform when volatility runs too high in a broad and severe market selloff. Still, Pil expects that managers focused on relative value are poised for success as they generally benefit in stretches of market uncertainty where the economy is chugging along.
“That’s actually a goldilocks environment for hedge funds to do well,” he said. “Stars are aligning for alternatives.”