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Portfolio 2010A compendium of investment perspectives from J.P. Morgan Asset Management

About

J.P. MorgAn Asset MAnAgeMent

This publication was edited, designed and produced by the institutional asset management marketing department at J.P. Morgan Asset Management.

©2010 JPMorgan Chase & Co. All rights reserved.

For more than a century, institutional investors have turned to J.P. Morgan Asset Management to skillfully manage their investment assets. This legacy of trusted partnership has been built on a promise to put client interests ahead of our own, to generate original insight, and to translate that insight into results.

Today, our advice, insight and intellectual capital drive a growing array of innovative strategies that span U.S., international and global opportunities in equity, fixed income, real assets, private equity, hedge funds and asset allocation.

t A b l e o f c o n t e n t s

2

foreword2010: An opening Act that needs no Introduction

4from great escape to great Handoff?by stu schweitzer and ehiwario efeyini

8strategic Investment themes in 2010by rumi Masih

13equities: the Year of Active Managementby Paul Quinsee

16

fixed Income: back from the brinkby seth bernstein

23

real Assets: real opportunityby Joe Azelby

29

Hedge funds: An Attractive Alternativeby Jef f gel ler

32

Hedge funds: A brave new World by corey case

f o r e w o r d

2010: An opening Act that needs no Introduction

J.P. MorgAn Asset MAnAgeMent 3

T He stIll nAscent oPenIng Act of this new decade needs no introduction.

The credit meltdown of 2008 and disruption of markets around the world have punctuated the prelude to the 2010s. Investors are still feeling their way in a brave new world. The issues of several years ago have been

largely eclipsed by a roster of new challenges ranging from liquidity and funded ratios to inflation anxiety and the de-risking (or re-risking) of portfolios. Fixed income, long held as the quotidian portfolio ballast, a sturdy base upon which riskier assets have typically been perched, experienced a paroxysm of pain before returning to normalcy. That period of spread widening in late 2008 and early 2009 created unprecedented challenges across a spectrum of credit strategies. Equities were in the cellar until March of 2009. Hedge funds hid behind their gates to halt redemptions. Real assets were next to impossible to value. The world, as most investors knew it, had gone awry.

Today, investors in the post-credit crisis era are examining new themes and with a new-found perspective. Reintroducing risk—by first identifying it within one’s portfolio and then selectively reinstating it to capture asymmetrical returns—is one among many concepts gaining currency today. The China story becomes more compelling with every spell-binding data point on industrial growth, productivity, urbanization and its ever-expanding domestic market. Globalization, private equity markets and a chastened but more com-petitive hedge fund industry now define a shifting landscape for the institutional investor.

There will be no easy answers. Finding a framework to help manage in this changing environment is perhaps the most critical and consequential step. Risk budgeting is gain-ing traction as considerations driven by returns-focused asset class allocations give way. Investors responsible for billions of dollars worth of assets face a new set of challenges and considerations, not the least of which is a rapidly evolving regulatory environment.

What is clear is that there is not yet a new “normal.” The Category 5 hurricane has come and gone but the skies remain gray. Yet from the tactical investment to the longer-term focus, there is still a myriad of promising opportunities available along the institutional spectrum.

For today’s investor in the institutional space—endowment, foundation, public or cor-porate plan, defined benefit or defined contribution—we offer herein a compendium of analysis and forward-looking insight. At J.P. Morgan Asset Management, we like to think that we have a bias toward thoughtful, considered discussion. We focus on client issues and let the product solutions follow organically. That is perhaps the paramount advan-tage of providing a multi-platform suite of experienced, proven investment strategies.

We invite you to read the following essays, consider their perspectives and engage in the great conversation with us—together—as we enter 2010.

4 PortfolIo 2010

Investors WIll reMeMber 2009 as the year in which the collective actions of governments and central banks around the world brought the global economy and financial markets back from the brink. But if last year’s story was one of a great escape from a potential sys-

temic collapse, 2010 is likely to prove somewhat more tricky. The central question for the year will be whether the global economy can successfully manage a “great handoff,” with private sector activity sustaining the economic recovery as the growth impulse from public sector stimulus begins to fade and financial markets are forced to face up to the reality of normal-izing monetary and fiscal policy stances.

Indeed, the early weeks of 2010 have already given investors a small taste of what could be in store this year. After a strong start to January, markets have come under renewed pressure as policymakers in China have begun to take small tightening steps and concerns have grown over the fiscal health of some of the smaller eurozone countries. Markets were able to shrug off last year’s rate hikes by central banks in Australia, Norway and Israel, as well as targeted tightening measures in a num-ber of the emerging markets such as Brazil, India and Turkey. However, the removal of stimulus in the larger developed markets may be harder to digest and it remains to be seen how markets will react to the ending of the Federal Reserve’s purchases of agency mortgage-backed securities at the end

from great escape to great Handoff? by stu schweitzer and ehiwario efeyini , G l o b a l M a r ke t s St rat e g i st s


of March or the expiration of the tax credit for U.S. homebuy-ers, which is currently scheduled for April. We would expect the major Western central banks to refrain from rate hikes for much if not all of 2010, but emergency policy measures will continue to be removed and talk of “exit strategies” will only increase as the year goes on. And while President Obama is pushing Congress to approve additional fiscal stimulus to pro-mote job growth in the U.S., the amount enacted may not be large enough to offset a falling impetus to growth from other public spending measures over the course of 2010.

The unintended consequences of government intervention will also be a cause for concern in 2010. Recent credit stresses in Dubai and Greece serve as chilling illustrations of how a loss of confidence in governments’ ability to honor their rising obliga-tions could unsettle bond markets and threaten to undermine the cyclical recovery.

Thus, whether or not the financial markets and broader economy can stand on their own will depend on the answers to two related questions: 1) Will private demand be strong enough to take up the slack from public sector support? 2) And how will market interest rates be affected by dete-riorating fiscal budgets, a cyclical recovery and potentially higher inflation expectations?

An economic recovery We can believe In

Our sense is that the U.S. and world economies will grow at a slightly above-trend rate in 2010, i.e., enough to lower unem-ployment rates, though not by much. Company inventories (still low relative to sales across the developed world) are only in the early stages of being rebuilt, and high corporate cash balances are likely to be used in part to fund new capital expenditures, especially after the sharp cuts of 2009. Moreover, despite the popular assumption that overleveraged households spell feeble future consumer activity, this sector should also contribute positively to growth in 2010. The recovery in asset prices over the last few quarters suggests that household savings rates have already made much of their upward adjustment, and so the prospects for spending should be determined in large part by income growth. Unemployment should only fall gradually over the course of the year, so we would not expect stellar growth in household income in 2010. But with work hours

already being rebuilt in the U.S., the number of employees on kurzarbeit (or shortened work weeks) in Germany beginning to fall and net hiring expected to turn positive on a sustained basis early in the year, moderate expansion in consumer spending should be expected.

J.P. Morgan Securities looks for GDP growth in the U.S. of 3.5% this year, with more subdued expansions of 1.6% in the eurozone and 2.0% in Japan. Admittedly, these are fairly paltry figures compared to what would be typical after such a deep re-cession, but they reflect the likelihood that private demand will nonetheless remain hampered by softness in bank credit exten-sion, weak demand for credit as some households continue to delever, only sluggish employment growth and an enduring glut of residential and commercial real estate properties. All this suggests that fears of a “double-dip” recession, though not an outcome we expect, are unlikely to be banished in 2010.

Stimulus side-effects will also cause some anxiety this year, but while we would expect market interest rates to rise moderately as the recovery progresses (and particularly as central bank as-set purchases run off), we do not believe that sovereign stress-es should pose a significant near-term risk to the expansion in major economies. Interest rates have so far managed to stay near historic lows despite the onset of recovery, and we would expect them to remain so this year. Competition for capital is likely to remain weak as credit demand from the private sector stays low and ongoing demand for Treasuries from households, investment funds and foreign creditors should also act to keep yields subdued (see Exhibit 1).

exHIbIt 1: A broAd-bAsed IncreAse In treAsurY deMAnd sInce tHe recessIon begAn

479332

2,499

693 802

3,584

0

500

1,000

1,500

2,000

2,500

3,000

3,500

4,000

Mutual Funds Households Foreign Creditors

Q108

Q309

Dol

lars

(bill

ions

)

Source: J.P. Morgan, Federal Reserve.

6 PortfolIo 2010

from great escape to great Handoff?

This could, of course, change if rising inflation pressures force central banks to urgently scale back their monetary support of the last two years. But we would not expect this either. Abundant excess capacity in labor and manufactured-goods markets is likely to make any inflation warnings sound more like cries of “wolf” in 2010.

An uneasy calm for MarketsS&P 500 operating earnings per share are expected to rise by 25% or more this year, as sustained cost containment and moderate economic growth allow firms to benefit from both revenue gains and wider profit margins. In addition, U.S. equi-ties still look very attractive on a free cash flow valuation basis, especially given today’s low borrowing costs (see Exhibit 2).

exHIbIt 2: corPorAte free cAsH floW YIelds reMAIn HIgH relAtIve to borroWIng costs

0.0

0.2

0.4

0.6

0.8

1.0

1.2

1.4

55 60 65 70 75 80 85 90 95 00 05 10

Year

U.S

. Equ

ity

Free

Cas

h Fl

ow Y

ield

/Ba

a Co

rpor

ate

Bond

Yie

ld (r

atio

)

Source: Empirical Research Partners Analysis, J.P. Morgan. Data as of December 2009. Based on a universe of large-capitalization U.S. stocks.

Local currency returns in non-U.S. developed markets—where labor shedding has been less aggressive, productivity growth has been weaker and slower economic activity is expected—may continue to trail behind the U.S. as they did last year (particular-ly in Japan, which remains stuck in deflation). However, we ulti-mately look for emerging markets to continue leading the way in 2010. In the near term, the warning shots being fired by Chinese policymakers may continue to weigh on emerging market equity performance, especially after last year’s strong investor inflows and substantial price gains. But the familiar Western challenges

of private sector deleveraging and rising government deficits do not apply in the emerging economies, where overall debt-to-GDP ratios are relatively low. And at around 6%, GDP growth for 2010 in the emerging world is expected to dwarf that of the developed economies this year. Add to this a potent cocktail of “imported” monetary policy accommodation and still reasonable valuations, and the case for emerging equities remains firm.

Though we expect a fairly benign 2010 relative to the mayhem of the past two years, there will still be plenty to keep inves-tors on edge. On top of fears over higher interest rates or an economic “double-dip,” unease will no doubt linger over the fate of the U.S. dollar and the political response to the crisis.

Despite the dollar’s recent reprieve, we would not expect the currency to exhibit sustained, broad-based strength. Indeed, we continue to harbor longer-term concerns, particularly over the substantial dollar reserve holdings of foreign central banks. In the near term, however, we do expect the dollar to show more resilience against the other major developed mar-ket currencies (euro, yen and pound). The similar headwinds from low interest rates and large projected deficits, the weaker growth prospects in those economies and the substantial gains those currencies have made since last March all suggest that further strength against the dollar may be limited. However, a self-sustaining recovery led by China and the emerging mar-kets should see commodity currencies continue to outperform.

Political risk is also likely to be a concern for investors this year. In the early weeks of 2010, markets responded nega-tively to the proposed “financial crisis responsibility fee” for U.S. banks, as well as the so-called “Volcker plan” that would prohibit deposit-taking banks from engaging in proprietary trading. Similarly, the recent decision by the U.K. government to introduce a payroll tax on discretionary bonus payments by financial institutions highlights the populist sentiment that the crisis has unleashed. The top rate of income tax is already set to rise in the U.K. this year while, in the U.S., the Bush tax cuts are scheduled to expire in 2011 and the Obama administra-tion is considering an extension of the Medicare payroll tax to investment income. We would not rule out other redistributive measures being discussed or enacted over the course of 2010 (especially as elections approach in both the U.S. and U.K.) and this represents another potential source of unease.


Despite the risks, we expect that a self-sustaining economic recovery, underpinned by strong corporate profit growth and supported by still easy (if gradually normalizing) monetary policy should allow the market trends that began in late 2008 and early 2009 to largely remain intact this year; i.e., higher prices for risk assets, rising bond yields and narrower credit spreads. But given the size of last year’s moves and the prospect of a less friendly policy environment, their vigor and consistency are unlikely to be maintained. We fully expect periods of unease and even crisis aftershocks in 2010, but an improvement in underlying macroeconomic conditions should make for positive—if moderate—returns for the year.

8 PortfolIo 2010

strategic Investment themes in 2010 by rumi Masih, H e a d o f t h e St rat e g i c I nv e st m e nt Ad v i s o r y G ro u p

T He recent credIt crIsIs came as a blunt reminder that sometimes when most needed, the benefits of diversification may not always deliver to expectations. Despite this reality, extreme events in financial markets are, by definition, a

rare phenomenon. And, importantly, they often present as many upside opportunities on the subsequent rebound as risks during the downside correction. Every crisis is unique, or unique enough that most investors are caught by surprise when the tide turns. To upend a popular aphorism, history does not, in fact, repeat itself. But there do appear to be recurrent patterns of dislocation that prudent investors should take account of in their strategic portfolio allocations. In the most recent instance, much like a disruptive wave that ema-nates from a pond ripple, overleveraging in sub-prime housing loans led to a systemic shortage of liquidity. Ten years ago, it was a misalignment in tech sector valuations vis-à-vis core earnings fundamentals that triggered a similar re-pricing. The timing of such macro events may be impossible to predict, but their mere plausibility should, in our view, inform risk-reward trade-off assessment in portfolio allocations.

One way to do that is by introducing a level of downside risk management and/or dynamic asset allocation based on time horizons into asset and liability management. For defined benefit plans, that would entail systematically adjusting risk


exposure as funded status changes. So as liabilities improve or deteriorate, risk would be taken off or taken on accordingly. In practical terms, that may mean separating liability-related investment decisions from return generation-related investment decisions. This could be incorporated as a holistic framework that effectively separates the liability decision from the underlying strategic asset allocation decision. The hedging portfolio’s role would then be primarily to minimize the impact of shifts in market factors such as interest rates on the volatility of the liabilities. The return generating portfolio’s main role would be to achieve the target return at a controlled level of risk (see Exhibit 1).

Downside risk management involves downside protection against “left tail” negative market events—such as Black Monday in 1987 or the Asian Financial Crisis a decade later. The chief benefit of implementing downside risk management, a concept which dates from the 1980s, is that it may help offset unforeseen collateral damage to portfolios from this type of non-normal market event. But as with any insurance mecha-nism, there are associated costs to capping risk, either explic-itly or in terms of a “right tail” positive event; In other words, returns forgone from having less exposure to riskier assets like emerging market (EM) equities, which have seen multiplier effect-like returns after bottoming out in early 2009.

A possible solution for putting that downside/upside risk trade-off into deeper context is the ascendant notion of dynamic, or horizon-based, asset allocation. This offers a new prism through which risk and return can be viewed from a longer- term perspective. Time horizons provide, among other things, a convenient framework for incorporating still unfold-ing trends such as global rebalancing. We will further discuss the concept of dynamism and horizon—and their application to portfolio allocations—after first describing the background against which they may come into play amid a constantly evolving investment environment.

Macro themes: lower correlation, Higher differentiation and greater dimensionalityHeightening the complexity of any portfolio allocation decision is the tectonic shift in capital flows that underpin financial markets worldwide. In some ways, the recent credit crisis can be seen as a milestone of sorts to mark one such change: a correction to a global imbalance caused by chronic excess consumption in the U.S. and Asian (more specifically Chinese) excess saving. In a reversal of long-standing practice, the U.S. savings rate has increased at the expense of a deleveraging consumer. At the

exHIbIt 1: bAlAnced PortfolIo strAtegY—MItIgAtIng rIsks WHIle seekIng enHAnced AlPHA

Source: J.P. Morgan Asset Management

RiskPortfolio

HedgingPortfolio

funding ratio

funding ratio

liabilities

fixed income views

technical data

liquidity

market views

liquidity needs

alternative programs

10 PortfolIo 2010

same time, emerging markets such as China and India have started to bolster aggregate demand and curtail reliance on export-based growth. All of that has potentially vast implications for the U.S. dollar (which may weaken further) and real interest rates (which may rise substantively). Indeed, EM savings rates have begun to plateau (implying higher consumption) even as developed economies’ saving rates are growing (implying less consumption) (see Exhibit 2). The longer-term implication of global rebalancing is a lower return premium on U.S. denomi-nated assets. To be sure, that premise may take decades to unfold to its fullest extent. In the meantime, as long as the U.S. dollar remains the preeminent reserve currency and inflation rates stay moderate, U.S. denominated assets will likely remain highly attractive to investors around the world.1

exHIbIt 2: eMergIng MArkets’ sAvIngs rAtes Are begInnIng to PlAteAu WHIle develoPed econoMIes’ sAvIngs rAtes groW

18

19

20

21

22

23

24

25

2000 2001 2002 2003 2004 2005 2006 2007 2008 20094.0

4.5

5.0

5.5

6.0

6.5

7.0Developed Markets (left scale)

Emerging Markets (right scale)

% In

com

e

% In

com

e

Source: J.P. Morgan, Goldman Sachs, IMF.

Beyond structural change in global balances, we expect a series of other, sometimes competing forces to alter the investment climate in heretofore unprecedented ways. These include a pro-nounced shift toward lower correlation, higher differentiation and greater dimensionality. Correlation among asset classes has declined from peak levels in late 2008 and now shows signs of being driven increasingly by divergent sets of fundamentals.

Likewise, differentiation is apparent across not only regions, but economies, asset classes, their embedded market cap struc-tures, sectors and strategies. Finally, greater dimensionality has arisen both among and within asset classes. For example, EM may be viewed very differently according to thematic buck-ets, including: commodity exporters vs. importers; domestic demand vs. external sector demand; banking sector vs. housing sector; demographic youth vs. demographic ageing; foreign di-rect investment hubs vs. foreign direct investment recyclers. In short, all EM are not alike—and less so by the day. One example of this can be seen in the wide spread in “peak-to-trough” inter-est rate cuts, which range from less than 400 basis points in China to nearly 1,000 bps in Turkey. (see Exhibit 3)

exHIbIt 3: WIde dIsPersIon In rAte cuts sHoWs dIfferent roAds to tIgHtenIng

0

200

400

600

800

1,000

1,200Ba

sis

poin

ts

Rate cuts from peak to trough from most recent policy rate cycle, 2006–2009

Turk

ey

Chile

New

Zea

land U

K

USA

Bra

zil

Sth

Afr

ica

Swed

en

Isra

el

Mex

ico

Hun

gary

Euro

land

Kore

a

Indo

nesi

a

Indi

a

Pola

nd

Czec

h Re

publ

ic

Taiw

an

Chin

aJa

pan

Source: J.P. Morgan Asset Management estimates.

Moreover, if inflation fears continue to abate, and aggregate market volatility declines or at least stabilizes in a lower band, investors will likely seek to commit a greater share of their portfolios to high yield strategies. Unlike previous recoveries, this move is likely to be hastened from a “need” rather than a “desire.” That is because liabilities have mounted steeply for most insurers and corporate pension plans. What’s more, a Federal Reserve Board that is likely to keep U.S. monetary policy accommodative for a considerable period, and Asian economies that are reluctant to tighten either externally (through stronger currencies) or domestically (through higher shorter-term interest rates), should maintain the U.S. dollar as a cheap funding currency with limited carry potential, at least over the short to mid term. Implications from this development

strategic Investment themes in 2010

1 For a fascinating study of aligning credit booms as a predictor of financial insta-bility, and its impact on the broader macroeconomy, see Moritz, Schularick and Alan M. Taylor (2009), Credit booms gone bust: Monetary policy, leverage cycles and financial crises,1870-2008, National Bureau of Economic Research, Working Paper 15512, http://www.nber.org/papers/w15512. The study finds that, while not a perfect predictor, credit contains valuable information as a precursor to financial crises in developed economies.


are manifold but would seem likely to encourage institutional investors to take more active risk beyond core fixed income and equities and into EM equity or sovereign debt exposure, multi-sector credit portfolios and commodities.

downside risk Management: exploiting Alpha but Paying to cap downside riskOne promising approach to managing downside risk is to intro-duce asymmetries and characteristics of left skew within portfo-lios. Indeed, it is our contention that there is tremendous value in actively managing asymmetric dependence in both equity and fixed income allocations within portfolios. Such value is largely a function of modeling the dependence structure amongst a given set of different equity indices. This dependence notice-ably increases during periods of market stress—particularly in severe bear markets (“fat” left tails) (see Exhibit 4). Downside risk management offers a way to address this issue. It works by limiting portfolio exposure to phases in the market that display this type of dependence amongst sectors of an asset class, or between alternative asset classes (like what took place during the most recent financial crisis), something which may lead to lower draw-downs and greater preservation of capital.2

exHIbIt 4: tAle of tHe tAIl: ‘fAt’ left tAIl MeAns greAter lIkelIHood of losses

0

2

4

6

8

10

12

-0.20 -0.15 -0.10 -0.05 0.00 0.05 0.10 0.15

Return (%)

Normal Observed

“Fat ” left tail

Den

sity

(%)

Source: J.P. Morgan Asset Management

2 For an empirical analysis of world equity markets illustrating these findings see Hatherley, Anthony and Jamie T. Alcock (2007), Portfolio construction incorporat-ing asymmetric dependence structures: A user’s guide, Accounting and Finance, 47(3): 447-472.

Depending upon the nature of tail risk (today we would point to the specter of inflation), hedging or insurance strategies can be implemented to specifically mitigate the negative impact of “fat” left tails. Inflation, for example, demands a consideration of TIPS, commodities and other real assets because they are expected to outperform other asset classes based on their track record during previous periods of recurring price gains. But as with any tail, there will be a probability that the risk does not materialize—and that asset prices may, in fact, rally. Hence, investors will need to consider allocation strategies that attempt to “square the circle” by incorporating a dual role of capping the potential source of a specific risk or set of risks, while at the same time exploiting alternative routes of alpha potential. A diversified commodity strategy that enables inves-tors to exploit alpha through physical delivery, quantitative anomalies, or access to hard-to-enter commodity markets is one such solution.

Commodities are typically correlated and, in some instances, lead inflation. But increasingly they have also come to incor-porate a fundamentally-driven allocative view due to excess demand from large emerging markets in Asia and elsewhere. In such an environment, it could be worthwhile for investors to consider infrastructure as an effective long-term hedge against inflation. Developmental infrastructure may provide a useful hedge against unexpected inflation over the long-term because replacement costs for tangible assets such as buildings, toll roads and airports follow inflation. In the short term, however, it bears noting that the impact of inflation on infrastructure returns could be negative as a function of depressed demand. Nevertheless, while sources of downside risk will no doubt evolve and present a constant challenge to identify, the way that portfolios are designed to mitigate these risks is likely to form a prevailing theme for some time to come.

Introducing Horizon into strategic Portfolios: seasonal change requires AdaptationAnother key theme likely to play out when investors structure their portfolios involves the concept of time horizons. Most in-vestors have been conditioned to accept a “centric” philosophy which holds that a portfolio is strategic and that asset allocation should therefore reflect assumption of risk, return and correla-

12 PortfolIo 2010

tion over a standard 10-year horizon. However, we posit that for the great majority of institutional clients, being strategic does not necessarily mean that some part of the portfolio cannot be engineered dynamically to exploit opportunistic sources of alpha operable in a universe within or well beyond that rather arbitrary decade-long time frame. Again, this may involve sepa-rate considerations for liability-related investment decisions and return generation-related investment decisions.

How best to do that? Bouts of volatility, deviations from fundamental value and supply disruptions of various pecu-liarities introduce opportunity for flexible asset allocation. This is, perhaps, nowhere more apparent than in pension plan portfolios that need to address liability issues and the likelihood of shortfalls. Why does introducing horizon into portfolios matter? And to what extent can this be practically implemented while maintaining strategic allocations? There is no set recipe. Numerous approaches can be expected to evolve—each with its own bespoke benefits and costs—but all embracing the fact that different horizons will allow different levels of leverage, liquidity, beta and alpha risk. According to our analysis, those horizon instruments and methods most worthy of consideration include:

i) Introducing some level of market dynamics into a portfolio. This does not imply that strategic asset allocation should now be substituted by its tactical counterpart on an across-the-board basis. Rather, one approach that could be used to assess the impact of market shifts involves recognizing how asset returns change in behavior contingent upon economic regimes. This involves a tripartite procedure of: (a) identify-ing historical regimes conditioned upon a set of factors; (b) estimating when and how the economy switches from one regime to another, and, (c) determining the joint behavior of asset returns within each regime.

ii) As pension plans have asymmetric risk appetites, making al-locations conditional upon their level of funded status could serve as a solution to allow plans to introduce and offload risk temporally. This mechanism would ideally allow a plan to vary its exposure to risk and encompass decisions around how much to hedge duration risk, what to include as assets to drive returns, and how to act on market views, in a more consistent and disciplined manner.

iii) Horizon may also be introduced into the portfolio by ap-plying the main tenet of the two-fund separation theorem.3 This theorem dictates splitting the total portfolio into halves: one that is responsible for generating returns and the other primarily engineered to either hedge liability risk or maintain a low risk threshold through cash or short duration fixed income. Separation not only adds efficiency but also may allow investors to exploit different horizons within each portfolio, especially as it relates to liquidity and allocation to alternatives.

conclusionIn retrospect, the rebound in U.S. economic growth from the depth of a severe economic recession, and subsequent retracement in financial markets, have been dramatic events to witness by almost any measure. Excess, both on the upside and downside, always seems to be exploitable only to a certain point—an inflection point beyond which Newton’s Third Law of Motion seems to apply. For some markets, the financial crisis was a very rapid and chaotic tsunami that swept over the finan-cial landscape and then retreated as quickly as it had appeared. Asset classes like commodities were involuntarily caught up in the churn, yet as soon as the crisis receded, they resumed more fundamentally-driven paths.

Not all assets escaped with as little damage, however. Financial sector equities, for one, have yet to fully recover from ingrained vulnerabilities in areas such as leveraging. And unlike any of the previous crises, the most recent market tumult may leave an indelible mark on investor tolerance for credit risk, in particular.

Whether or not a given investor’s preference for a healthier risk appetite grows over time, market undulations are likely to continue to be a permanent—if not always prominent—feature of the financial landscape, and this will drive asset tactical allocation decisions for many investors. However, in order to position portfolios for optimal long-term performance, we would argue that strategic allocations also should be informed by a broader set of considerations, including downside risk management and time horizons.

3 The first two-fund separation theorem was introduced into the literature by James Tobin (1958), Liquidity preference as behavior towards risk, Review of Economic Studies, 25, 65–86. For this concept in a practical context, see Nikko Canner, N. Greg Mankiw and David N. Weill (1997), An asset allocation puzzle, American Economic Review, 87, 181–191.

strategic Investment themes in 2010


T He recent beAr MArket in equities ranks as one of the most unpleasant on record; the S&P 500’s decline of 38% in 2008 was the worst annual result since the 1930s. The index has also fallen over the past decade, again for the first time

since the Great Depression. So what impact has this had on the business of equity investing?

At first glance, one might conclude that little has changed. Stock prices have recovered smartly since the first quarter of 2009, and the S&P 500 has retraced about half of the losses suffered from the peak in the fall of 2007. Market volatility, which hit highs not seen in any living investors’ career (at least in domestic markets), has quickly receded, while the volatility of individual stocks within the market is back to pre-crisis levels. Professional investors, who manage the vast majority of U.S. equity investments, have quickly shifted their preference from the most defensive, least risky stocks back towards much more cyclical choices, taking advantage of the widest spread in valua-tion between cheap and expensive names for a very long time.

But behind this reassuring picture, it is clear that attitudes to-ward domestic equity investment have been deeply scarred by the last decade. In particular, individual investors have contin-ued to reduce their allocations to domestic equity mutual funds even as the market has recovered. Flows have been heavily

equities: the Year ofActive Management by Paul Quinsee, C I O, U .S . La rg e C a p Co re a n d Va l u e

14 PortfolIo 2010

directed toward bond funds. In fact, in 2009 investors bought $313 billion worth of bond funds, compared to a net outflow of $2 billion in equity funds. In addition, equity allocations are being rebalanced in favor of international exposure, especially emerging markets. There appears to be a very strong consen-sus that returns elsewhere will continue to be better than the returns from U.S. equity, just as they have been over the past ten years. Outflows from large cap funds have been especially noticeable. We have to go back to 2000 to find the last time that individual investors were enthusiastic about opportunities in large cap domestic stocks.

Meanwhile, the trends in institutional investing look very simi-lar. Equity allocations are being reduced, and the proportion of those investments allocated to domestic stocks is continuing to decline. At a recent J.P. Morgan institutional client event, only one investor in a room of over a hundred clients signaled a will-ingness to allocate more to domestic equity over the next year.

Is this wise? On the one hand, many observers have argued for years that both individual and institutional investors typically allocate more to domestic equity and less to international equity than is theoretically desirable. So from that perspective, the shift overseas would seem to make perfect sense now—and for some time to come. What’s more, an argument could be made that individual investors have probably over-allocated to

equity during the good times, and therefore may need a higher fixed income weighting in any case as they grow older. But a skeptic would point out that both this new found enthusiasm for fixed income, and the persistent appetite for international stocks, may be fuelled in large part by a desire to chase the re-turns of the past ten years. A typical Core Fixed Income mutual fund, for example, has returned a cumulative 90% after fees over the past decade, while Core Large Cap Equity returns are barely positive. International equity funds have done better, with an average cumulative return of over 16%. Moreover, the current risk premium of equities over both government and corporate debt is very attractive, almost twice the average that we’ve seen over the past 25 years (see Exhibit 1).

The case for domestic equity is a hard one to make in the face of the conventional wisdom that the U.S. economy will under-perform, weighed down by sluggish consumer spending and large government deficits. But, of course, we invest in corporate securities, not economies. And the U.S. corporate sector today looks to be in surprisingly good health when one considers the gloomy economic backdrop. In the third quarter of 2009, large cap companies generated an annualized 8% free cash flow yield, and almost $70 of earnings on an S&P 500 basis. Near term, American companies have again shown an impressive cost discipline and an aggressive focus on maintaining cash flow in a harsh environment. Behind this, the full longer-term benefits

equities: the Year of Active Management

exHIbIt 1: AttrActIve eQuItY rIsk PreMIuMs vs. treAsurIes… …And corPorAte bonds

Note: The above charts are for illustrative and discussion purposes only. Equity risk premium is equal to J.P. Morgan Asset Management Dividend Discount Rate on S&P 500 stocks, less current yield to maturity on 10-year U.S. Treasury bonds and BAA Corporate bonds. A dividend discount rate (DDR) is the discount rate which equates the pres-ent value of the estimated stream of future dividends to the current market price. The J.P. Morgan S&P 500 DDR is a bottom-up, sector-neutral and capitalization weighted average of dividend discount rates (DDRs) on large-capitalization stocks as estimated by J.P. Morgan Asset Management equity research analysts. A DDR does not represent a stock's expected actual return in any given time period. Source: J.P. Morgan Asset Management. As of December 31, 2009

-2

0

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1986 1988 1990 1992 1994 1996 1998 2000 2002 2004 2006 2008

Equi

ty R

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of the globalization of the supply chain and the use of technol-ogy are still being discovered, with the effect of reducing capital intensity and improving returns on equity. We see normalized earnings of $95 per share for the S&P 500 two years out, which makes the market look very reasonably valued.

the Wild cardPerhaps the biggest risk to this forecast comes from the dif-ficulty in predicting the policy response to the turmoil in the financial sector over the past three years. It seems highly likely that regulation will impact the profitability of the financial sector, and that taxes will rise for both individuals and corporations to help repair the damage done to the nation’s fiscal position. More broadly, the level of government involvement in many sectors appears to be on the rise, with healthcare the highest profile ex-ample of that trend. What this means for profitability isn’t clear, but it is unlikely to be highly positive.

Still, overall we think that investors are overly pessimistic on the outlook for U.S. equities, at least relative to both lower risk assets (bonds) and to other equity markets glob-ally. Strong cash flows and reasonable valuations should sup-port a much better return scenario than has been the case over the past decade.

Although the returns from beta have been slim indeed for many years, there has been one consolation—the returns from active management have been unusually rich. In managing our U.S. Equity business, we assume that if we can beat the market by 2% per year over time, we will achieve top quartile perfor-mance. Over the past 20 years, that’s been true; indeed, the 25th percentile manager has beaten the market by 0.6%. Over the past ten years, we find that the level of alpha required to achieve that top quartile goal has been over twice the long-run level. To boast of top quartile returns, an active manager needed to have outperformed the benchmark by over 4% per year. Even the median manager has been ahead by 2.5% an-nualized over the past decade.

The collective success of active managers has, in my experi-ence, had a lot to do with the returns to value investing, the performance of large vs. medium-sized and smaller stocks, and the level of opportunities to add value by venturing out-side the benchmark. The last decade has been a near perfect

environment because spreads between cheap and expensive stocks had grown extremely wide by the end of the ‘90s, the peak of the Internet bubble. Since then, value investing has worked very well, with the painful exception of 2008. Mean-while, the most expensive stocks in 1999 were also the largest stocks. Underweighting these has been a consistent source of alpha, again with the brief exception of 2008. And managers that didn’t constrain themselves to the S&P 500 but also chose names from the mid cap world or from international markets found that the odds were very much in their favor as shown by returns that outperformed peers.

So no beta, plenty of alpha. The exact reverse of the ‘90s. Is it a coincidence that the most popular institutional vehicle is now the hedge fund, while in the ‘90s enhanced indexing was the in vogue strategy?

conclusionLooking forward, I see a return to a more normal relationship between the returns to the market and returns to manager skill. Value spreads have narrowed, large stocks actually look very cheap to us, and the returns from international markets are unlikely to provide quite the same level of boost to a domestic equity portfolio as has been the case for some time. A man-ager with good insights should still be able to deliver attrac-tive results, but to capture those insights effectively, the more efficient forms of portfolio construction (enhanced indexing and 130/30) are likely to provide a competitive advantage. I would also expect that quantitative managers will be at much less of a disadvantage from here on out. As the period of exceptional volatility passes, many quantitative stock selection tools are likely to prove more effective again. That’s all the more so since “quants” typically have been bigger users of enhanced index and long/short portfolio techniques to make the most of value-added insights.

Given the low expectations, and the remarkable health of the corporate sector, I would expect market returns to reach long-run averages. As that happens, U.S. Equity is likely to slowly regain favor, and provide stiffer competition to other asset classes. Even so, the market is likely to provide a tougher adversary for active managers than has often been the case over the last decade.

16 PortfolIo 2010

fixed Income: back from the brink by seth bernstein, H e a d o f G l o b a l Fi xe d I n co m e a n d Cu r re n c y

If ever tHere WAs A YeAr in which bond markets have experienced both the deepest agony and the greatest ecstasy, it was 2009. The year began with credit markets still mired in crisis and the U.S. facing a deep recession accompanied by rising consumer and

corporate defaults. But by March, the worst of the storm had passed and by mid-summer the market was on pace for record-setting returns. By year-end, most fixed income inves-tors were breathing a deep sigh of relief. But their comfort level has been held in check by the unprecedented govern-ment support needed to catalyze the rebound. While signs of recovery have begun to appear in the broader economy, many acknowledge that growth remains weak, with high unemploy-ment and rising defaults in mortgage-related securities acting as a drag on market sentiment.

In this essay, we will take you back through the highs and lows of 2009, reviewing the stellar performance of various fixed in-come sectors and then attempt to identify attractive investment opportunities in 2010. We will also examine both the near- and longer-term risks associated with those opportunities.

That said, we will state upfront that it is important, in our view, to recognize that near-term risks in higher-quality credit markets will likely continue to be well-priced and that high-yield securities and distressed mortgages offer some


remaining potential for current income and capital apprecia-tion. However, the greatest risks still reside in those sectors that have lagged the most, i.e., commercial mortgages, and even in Treasuries, where rates have continued to go up. For the longer term, we are more focused on the potential for higher inflation arising from increased U.S. indebtedness and loose fiscal and monetary policy.

looking back at fixed Income Performance in 2009On December 31, 2008, the U.S. 10-year Treasury yield closed at 2.21%, having risen 16 bps in a short trading session. The previous day’s yield of 2.05% was the lowest recorded since the U.S. Federal Reserve first began tracking daily data in 1962. Also in December 2008, the Fed fixed the short-term interest rate in a range of 0% to 0.25%, but in practice the rate often traded into negative territory due to the emphasis on safety for many market participants. The option-adjusted

Agencies Mbs Abs

cMbs Inv.

gradeu.s.

credit

Inter- mediate

creditlong

credit

u.s. High Yield eMd

QuAlItY rAnkIng High High High High Medium Medium Medium low low

1998 -49 -90 -88 n/a -238 -150 -381 -843 -2046

1999 41 113 137 87 170 164 182 476 2417

2000 -13 -77 43 -41 -463 -237 -1003 -1897 148

2001 73 -75 139 131 277 138 667 -285 -541

2002 96 173 -16 210 -187 -129 -371 -1329 23

2003 27 11 181 201 527 439 824 2642 2465

2004 78 142 142 118 159 151 190 800 823

2005 13 -37 32 15 -85 -25 -291 47 959

2006 75 122 87 137 119 107 156 843 702

2007 -52 -185 -634 -435 -464 -399 -655 -777 -457

2008 -110 -255 -2223 -3274 -1786 -1504 -279 -3832 -2842

2009 238 482 2496 2960 1990 1707 2880 5955 3797

spread (OAS) of the Barclays Corporate Index widened to 555 bps, U.S. Agency Mortgage Backed Securities (MBS) OAS hit 226 bps and the high yield index skyrocketed to 1,660 bps. Price indications were hard to find for non-agency mortgages and bids even more difficult to obtain. The markets had seized up and prices reflected a pervasive fear of systemic risk.

Exhibit 1 illustrates the enormous snap back in fixed income returns in 2009. Each column represents the excess return of a specific fixed income sector each year since 1998. The excess return is that component of total return not related to Treasury movements; hence, it is the portion due to spread and spread changes. Every sector had negative excess returns in 2007 and 2008; However, 2009 was different. High yield, for example, saw excess returns of 59% in 2009. This represented by far the most profitable year in the history of modern fixed income markets. (It is important to remember, however, that an invest-ment that was down 35% in one year and up 50% in the next year is still -2.5% for the two-year period.)

exHIbIt 1: bArclAYs cAPItAl fIxed IncoMe IndIces relAtIve to treAsurIes (excess return) 1998–2009

Source: Barclays Capital Note: The above table is shown for illustrative purposes only

18 PortfolIo 2010

fixed Income: back from the brink

As investors were lured back into riskier sectors and as the recovery gained momentum—becoming even stronger than many anticipated—Treasury rates began rising once again. As a result, prices have been falling and the curve has been steepen-ing, producing negative returns across all maturities in recent months, particularly for longer-dated securities (see Exhibit 2).

exHIbIt 2: cHAnge In u.s. treAsurY YIeld curve, returns

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urn

2010 challenges and opportunities: corporate bonds & MortgagesAs we expect these broadly positive trends for the economy to continue in 2010, many investors are wondering: “How do we survive a rising interest rate environment?” Below, we talk about some of the challenges that impacted each sector in 2009 and where opportunities to protect against rising rates may exist in the year ahead.

corporate bonds

The market for corporate credit, particularly high yield, whip-sawed from having the worst year on record in 2008, to expe-riencing the best year ever in 2009. At the peak of fear and un-certainty, spreads in high yield widened to twice what they were in any previous recession. Exhibit 3 shows historical spreads for the JPMorgan Global High Yield index as well as trailing default rates. In recent weeks, the level has hovered at approximately 750 bps, which is 1,000 bps lower than it was in early 2009, and

Maturityend of

Period YieldYear-to-date

change

Year-to-date rate of return

2 year 1.14 0.37 1.29

5 year 2.68 1.13 -1.35

10 year 3.84 1.63 -9.76

30 year 4.64 1.97 -25.88

Note: All data as of December 31, 2009Source: Barclays Capital and BloombergThe above graphs are shown for illustrative purposes only

Note: All data as of December 31, 2009Source: J.P. Morgan Asset ManagementThe above graph is shown for illustrative purposes only. Opinions and statements of financial market trends that are based on current market conditions constitute our judgment and are subject to change without notice.

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2000 Domestic HY Default Rate

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exHIbIt 3: HIstorIcAl sPreAds of tHe JPMorgAn globAl HIgH YIeld Index


less than 200 bps above its long-term average of 582 bps. At the same time, trailing 12 month domestic default rates have declined to 10.91%, after a steady march upward during 2009 to levels well above the long-term average of 4.48%.

We believe that spreads have tightened in front of a justifiably anticipated improvement in credit conditions. Nevertheless, we remain constructive going forward on both the technical and fundamental outlook for corporate credit. Corporate fundamen-tals have, in our view, bottomed out and are likely to continue to improve in 2010. Of course, the revenue side of the corporate equation appears weak, in spite of nascent signs of improved re-tail spending and industrial production, and the large de-stock-ing of inventory. On the other hand, firms have been particularly prudent on the cost side by curtailing capital spending plans and labor expenses, resulting in better-than-expected profit-ability and free cash flow generation. We believe this improved profitability, combined with better access to capital markets and funding, will result in lower default expectations, perhaps down to the long-term average of 4% to 5% within the next two years. Indeed, as Exhibit 4 shows, the number of defaulted companies peaked in April 2009 and has been declining ever since then. To be sure, the risk of a “double dip” recession remains, but we think the government focus on growth over inflation will keep interest rates low and, consequently, continue to provide sup-port to the high yield market.

exHIbIt 4: nuMber of defAulted coMPAnIes In HIgH YIeld

9

5 54

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of d

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Source: J.P. Morgan; S&P/LCDNote: The above information is shown for illustrative purposes only.

Additionally, despite the force with which spreads have rebounded from their wides in 2008, we still believe there is opportunity in the corporate bond sector, both for high yield and investment grade credit. Bull markets can last for several years and we have just finished the first year of a possible two-to-three year run. Therefore, we expect spread recovery to continue as there is still ample room in select sectors to tighten based on historical standards (see Exhibit 5).

exHIbIt 5: corPorAte bond sPreAd recoverY over tIMe

200

400

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1,000

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1 4 7 10 13 16 19 22 25 28 31 34 37 40 43 46 49 52 55 58

Jan '89–May '93 Apr '99–Oct '03 May '07–Dec '09

Dec '09724 bps

Dec '90 1096 bps

Nov '081798 bps

Sep '021070 bps

Oct '03533 bps

May '93404 bps

Number of Months

Spre

ad to

wor

st (b

ps)

Source: J.P. Morgan High Yield Index

At the same time, the massive spread compression of last year is not likely to be repeated anytime soon. Even so, investors may benefit from the incremental yield pickup provided by owning corporate bonds. Exhibit 6 shows that the end of a bull market cycle typically corresponds with the end of a Fed tightening

exHIbIt 6: HIstorIcAl sPreAd tIgHtenIng 1971–2009

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1971 1975 1979 1983 1987 1991 1995 1999 2003 20070

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30Start of Tightening Policy through low in Corp Spreads BBB vs UST 10s (lhs) Federal Funds Target (rhs)

Source: Federal Reserve

20 PortfolIo 2010

cycle, not with its start. And although some central banks around the world have begun tightening, we believe there is still room to run as the Fed has repeatedly restated a commit-ment to maintain high liquidity levels in the U.S.

Mortgages

Despite the broad improvement in fundamentals, the picture is more muddied on the mortgage side. Agency MBS performed very well last year, with over $1.4 trillion in new issuance and 11 consecutive months of spread tightening in the sector through November of 2009. However, more than $1 trillion of the total amount was purchased by the Fed, keeping rates and prices in control. While the overall sector has benefited from the Fed purchases, concerns remain that spread volatility will increase as the Fed begins to withdraw its involvement from the agency MBS market.

Of course, the real focus has been—and continues to be—on the non-agency mortgage market. Similar to other distressed sectors, non-agency mortgage prices appreciated handsomely in 2009. Indeed, prices in the sector rose about 50% last year, up from a low of around $60. Exhibit 7 shows the price of a representative prime fixed rate non-agency security. Much of the price appreciation resulted from technical support for the sector, including: new entrants to the sector (hedge funds and others interested in distressed assets); new structures creat-ing a floor for prices; little-to-no new primary supply; Public-Private Investment Program (PPIP) funds driving prices higher; attractively high yields and the knock-on effect of Fed support for the agency MBS market.

exHIbIt 7: rePresentAtIve non-AgencY Mbs securItY dollAr PrIce

55

60

65

70

75

80

85

90

95

100

105

Dec 07 Mar 08 Jun 08 Sep 08 Dec 08 Mar 09 Jun 09 Sep 09 Dec 09

Source: IDC, Bloomberg. The above chart is shown for illustrative purposes only.

However, the fundamental credit picture impacting the residential mortgage sector remains unclear. The economic environment, although healing, suggests caution as the hous-ing recovery has been somewhat tepid. Although the Housing Affordability Modification Program (HAMP) has slowed the foreclosure process, it has done little to solve the problem of the weak credit profile of the underlying borrower. Exhibit 8 shows the number of homes in foreclosure or those owned by servicers, or real estate-owned (REO).

exHIbIt 8: nuMber of HoMes In foreclosure, reos

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1,000

Jan 05 Jul 05 Jan 06 Jul 06 Jan 07 Jul 07 Jan 08 Jul 08 Jan 09 Jul 09

00

0s

Foreclosures REOs

Source: J.P. Morgan Chase & Co.

When the crisis began, the market priced in a substantial rise in foreclosures and losses within securitization pools. But since then, the loan modification program has helped stabilize the foreclosure and default rates and has contributed to the decline in REO properties (orange line in exhibit above) result-ing in market optimism and a rise in prices. Yet we believe there is a risk this dip may be a false positive, particularly with a “shadow inventory” of seriously delinquent and foreclosed loans which continues to rise (blue line in exhibit above). The reason for this inventory is due to:

A large number of foreclosed properties not yet owned by •servicers due to last ditch modification efforts

A rising number of loans at least 90 days delinquent•

Recidivism: the re-default of previously modified loans •subsequently deemed un-modifiable and “left for dead”

Loans in an as yet early stage of non-performance•



Serious delinquencies across the various non-agency product types (i.e., Option ARM, Subprime, Alt A) suggest that this “shadow inventory” has been growing dangerously large of late. The most serious delinquencies have been in the subprime sector, with close to one million properties considered seriously delinquent. As we expect the liquidation of these properties to take another two to three years, it is clearly difficult to make broad predictions about the opportunities in this sector. We do believe such opportunities exist, but that selective evaluation and investment in this sector will be critical to success.

so Where do We go from Here?Clearly, government intervention was a necessary evil to pre-vent disaster in the financial markets. But as we communicated to clients a year ago, new risks are being created. The massive liquidity injection by the government and its intervention in pri-vate asset markets may have been necessary to cure this crisis, but it is also creating new distortions. Hence, current market prices do not clearly reflect risk and their adjustment to the withdrawal of government support is unlikely to be painless.

The growth of the Fed’s balance sheet and government debt could have a profound influence on fixed income markets in years to come. Exhibit 11 shows the trillion dollar growth of the Fed’s balance sheet, mostly from purchases of Agency MBS and other securities. Exhibit 12 shows the growth in debt issuance in the last year and its projected growth, based on expectations of future deficits. Already, Treasuries have grown from 22% ($2.06 Trillion outstanding) of the Barclays Aggregate Benchmark at the end of 2007 to about 27% ($3.01 Trillion outstanding) in December of 2009.

Right now, the high degree of slack in the economy is helping to subdue the immediate risk of inflation. However, infla-tionary expectations also rest on faith that the Fed will be able to reduce its balance sheet and adjust monetary policy smoothly. This thinking assumes relatively contained import and commodity prices as well. But over the longer term, we believe the size of fiscal and monetary imbalances in the U.S. carry appreciable risk of higher inflationary expectations and increased sovereign risk.

exHIbIt 11: totAl Assets Held bY u.s. federAl reserve

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lars

in b

illio

ns

Source: U.S. Federal Reserve

exHIbIt 12: u.s. budget bAlAnce And net IssuAnce

-1,600-1,400-1,200-1,000

1,0001,2001,4001,600

-800-600-400-200

0200400600800

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UST Coupon Net Issuance, $bn*Government Budget BalanceEstimated

* Net marketable debt outstanding, excluding T-bills and annual net coupon issuance.Source: CBO, Barclays Capital Live

22 PortfolIo 2010

These risks suggest it may be prudent for investors to protect their portfolios against higher rates of inflation by, for in-stance, considering more international exposure. In our view, credit strategies are likely to provide relative outperformance versus Treasuries and to protect against rising interest rates. Corporate bonds, in particular, are a high conviction risk al-location for us, but—importantly—with a strong emphasis on issuer selection. High yield, we expect, will continue to be a top performing sector in 2010. Despite continued uncertainty in some of the securitized mortgage sectors, pre-2006 vintage non-agency residential mortgage-backed securities also may provide value potential.

Lastly, in 2010, we believe that emerging economies should continue to lead the global recovery, and inflation in these countries, for the most part, will likely remain well anchored. While difficult to make long-term predictions, we expect the market environment to be more volatile and full of opportunities as well as risks in 2010. As a result, exposures to local emerging markets debt and currency investments may be poised to outperform.

conclusionThe dramatic recovery in credit markets in 2009 came on the back of significant government intervention. While opportuni-ties remain for select fixed income investments, these are obvi-ously somewhat diminished compared to a year ago. Further, particularly in residential mortgages, we believe that any investment requires a careful assessment of underlying credit risk, especially amid mixed signals for the broader economy. What’s more, continued government intervention could result in heightened inflation risk over the longer term. Those risks bear close watching, especially amid expectations for continued strong growth in emerging economies, ongoing dollar weakness and higher commodity prices—all potential catalysts for higher rates of inflation globally.

For the fixed income investor, we believe the intermediate ho-rizon is likely to offer a relatively stable and improving spread environment, relatively contained interest rate movement and opportunities relatively untainted by excess leverage and complex structuring.



Just A feW YeArs Ago, the definition of a well-diversified portfolio meant 60% publicly-traded stocks and 40% bonds. Today, balanced strategic allocations are more along the lines of 35% fixed income, 50% equity and 15% in real estate and alternatives such as

hedge funds and private equity. As portfolio construction theory continues to evolve, institutional investors will likely seek even greater asset class diversification. In ten years’ time, the “port-folio of tomorrow” might comprise 30% bonds, a 35% mix of public and private equity, 10% in absolute return strategies and up to 25% of “real assets” such as commercial real estate (CRE), infrastructure, other long life operating assets and commodi-ties. Real assets may become increasingly attractive as an omni-bus asset class because, in our view, they are a natural exten-sion of two secular trends—globalization and urbanization—and one developing concern—inflation.

Of course, real assets—and CRE in particular—have not been immune to the sharp decline in asset values in this recession. However, real estate has re-priced much more rapidly in this cycle than in the last major downturn. Commercial property values have been written down more in the past six quarters than they were in the entire early-1990s down cycle—when it took over six years to complete its decline. In addition, occu-pancy has remained more stable in this down cycle as we have avoided the massive give-back in space when tech tenants

real Assets: real opportunity by Joe Azelby, H e a d o f G l o b a l Re a l As s e t s

24 PortfolIo 2010

vaporized after the Internet bubble burst. Plus, the pipeline of new supply for office buildings relative to the existing stock is small in comparison to prior growth cycles. (Condos in Florida, however, are a different story.) Commercial real estate price movements lagged on the way down and we expect values to lag the economic recovery on the way up. If you have mus-tered the courage to review your 401(K) or 529 Plan state-ments recently, you’ll notice that global stocks and every type of bond have recovered dramatically. The economic recovery is underway and, as expected, commercial real estate may be the only train that has not left the station. In our view, this means that a very attractive entry point in 2010 and 2011 is unfolding. Investors who actively invest during periods of market stress, much uncertainty and negative headlines have historically been rewarded with outsized returns.

Whether it’s the repair of crumbling infrastructure in the U.S. or the “new build” infrastructure required in Asia, infrastruc-ture has attracted the attention of government and industry around the world. Both the West and the East need to address these needs if their countries are to maintain the level of pro-ductivity required to remain competitive. The amount of capital needed is enormous and governments must provide the right framework to attract investors seeking attractive risk adjusted returns. We believe that is happening and that investors will be rewarded for helping to meet this critical need. Infrastructure has enduring appeal to long term investors because once it is operational it tends to be less impacted by short-term demand and supply swings from secular business cycles.

the Abcs of opportunityAmid signs the recent cyclical downturn has bottomed out—both in emerging and developed economies—we expect broader growth trends to once again accelerate. We have identified a series of “games changers” reflecting global economics, gov-ernment policy, bank regulation and the misfortune of irratio-nally exuberant investors and their bankers that savvy investors can exploit to their benefit. Among the most important of these developments are: (a) the rise of Asia as an economic power-house, (b) disposition of bank-held real assets, (c) the impact of climate change, (d) the re-emergence of distressed invest-ments, (e) increased alternative energy demand, (f) heightened inflation risks (real or perceived) and (g) increased government

real Assets: real opportunity

involvement in business. What follows is a discussion of each of these game changers and why they may strengthen the case for increased exposure to real assets in terms of strategic portfolio allocation—both now and in the future.

A Is for AsiaWhy focus on Asia? Simply stated, there are 2.5 billion good reasons—i.e., the combined populations of China and India, two of the world’s largest and fastest growing economies. In our view, these two increasingly important actors on the global economic stage will likely create new demand drivers for real assets, which should, in turn, produce attractive rates of return. Consider, for example, raw growth rates in gross domestic product. China and India are estimated to have posted positive GDP for 2009 (8.6% and 6.8% respectively), whereas the euro zone and the U.S. GDP shrank last year (an estimated -3.9% and a preliminary -2.4% respectively), according to our most recent projections at J.P. Morgan. Even once a sustainable global recovery gets underway, both China and India are expected to continue to grow at close to double digit rates annually, while Europe and the U.S. are expected to grow only 3% to 4%. The torrid pace of Chinese and Indian GDP growth is a by-product of massive economic and so-cial transformations that are underway in these and other emerging countries. Most notably, this has taken the form of large-scale and rapid urbanization, which has created a continuously booming commercial and residential real estate market that has been relatively immune to the bursting of asset bubbles in the West.

This organic growth in Asia has vastly increased global demand for basic infrastructure and supplies of raw materi-als. Emerging economies’ appetite for commodities is surging as they industrialize to meet domestic and export-market demand for manufactured goods. At the same time, Asian governments are overseeing a huge build-out of core eco-nomic and social infrastructure to ease the strain from rapid urbanization. Those needs include distribution networks, power plants, transportation hubs, water works and social infrastructure (e.g., hospitals, schools, prisons). Each of these areas may present opportunities for investors in real assets to participate in the Asian growth story.


b Is for banksAs the epicenter for the global financial crisis, the banking system’s woes have become a proxy for the larger global downturn. While the worst of the crisis may be past, banks are still dealing with the fallout from the financial markets’ swoon. Loans that seemed reasonable at the market peak now expose lenders to significant defaults and possession of collateralized assets such as CRE, ships and infrastructure. It’s important that investors focus on these “unnatural” own-ers as potential sellers of distressed assets. Today, banks are postponing the inevitable by extending loans and delaying losses. But crisis breeds opportunity. Once they build up their loss reserves, banks should be able to recognize these losses. Subsequently, we believe many of the distressed assets on bankers’ books will find their way to market. This anticipated overhang of distressed commercial and multifamily property loans already has begun to grow, with its share of all such CRE loans in the U.S. expanding from just above 1.0% in June of 2007 to 5.0% as of September of 2009, according to data from the Federal Deposit Insurance Corporation (FDIC) and J.P. Morgan (see Exhibit 1).

exHIbIt 1: dIstressed loAns And reAl estAte oWned As A sHAre of coMMercIAl And APArtMent loAns

0.0

1.0

2.0

3.0

4.0

5.0

6.0Foreclosed real estate (REO) Assets in nonaccrual status Past due days +90 Past due 30–89 days

Perc

ent

$68bn

Jun

07

Sep

07

Jun

09

Sep

09

Dec

07

Mar

08

Jun

08

Sep

08

Dec

08

Mar

09

Source: J.P. Morgan, FDIC

A subset of this development is government ownership of especially troubled banks. While stronger banks have been able to tap public markets to replenish their depleted capital reserves and—in some cases—finance acquisitions, weaker banks remain a cause for widespread concern. Fears of a contagion effect have prompted many governments to

inject public funds into weaker banks, resulting in the full or quasi-nationalization of a number of lenders globally. As a result, these banks are undergoing government-orchestrated restructurings designed to neutralize non-performing assets. This presents significant potential as CRE and other tan-gible assets are sold off and spun out as part of government sponsored restructuring efforts, not only in the U.S. but also in Western Europe. We view the next couple of years—maybe even into 2012—as attractive vintage years for buying from these “unnatural” owners in the financial industry as they are forced to liquidate non-core real assets.

c Is for climate changeWhether one believes the causes of global warming are man-made or not, we envision many new investment opportunities at the busy junction where government policy, infrastructure development, private capital investment and environmental concerns intersect with one another. One of the most im-portant aspects of climate change involves simply reducing the global “footprint” by lowering consumption of energy overall. That can involve everything from a build-out of more robust public transportation networks and a “smart grid” for electricity transmission to “green” buildings that incorporate energy-saving devices and recycled materials. With ample support from the public sector in the form of specific policy initiatives, we believe that environmentally-friendly infra-structure and CRE also will be a growth area for investors.

More than one billion square feet of non-residential CRE in the U.S. (including office, industrial, retail and flex buildings) already have gone green by virtue of having attained either Leadership in Energy and Environmental Design (LEED) status from the U.S. Green Building Council or Energy Star certification, according to CoStar Group. What’s more, while that accounts for only a small percentage of total U.S. office inventory, fully 23% of major (100k sf and larger) office buildings delivered in the U.S. since 2007 have attained En-ergy Star (8%) recognition from the U.S. Environmental Pro-tection Agency and the U.S. Department of Energy or LEED certification (15%). In fact, properties with a LEED green building rating have enjoyed a substantial rent premium over conventional construction, according to data from

26 PortfolIo 2010

independent research firm CoStar Group Inc. (see Exhibit 2). In our view, LEED certification is likely to catch on not only in mature markets such as the U.S., Western Europe and Japan, but also among emerging economies facing ris-ing social costs from their rapid economic development.

exHIbIt 2: green HAs HAd HIgHer dIrect rentAl PreMIuMs

23

26

29

32

35

38

41

44

47

50

53

1Q06 2Q06 3Q06 4Q06 1Q07 2Q07 3Q07 4Q07 1Q08 1Q09

LEED properties

LEED peers

Dol

lars

per

squ

are

foot

Source: CoStar Group

d Is for distressedWhile banks may become a large repository for distressed collateral, as mentioned previously, they are far from the only sellers when it comes to real assets such as CRE, infrastructure and maritime assets. In core CRE, there’s been a much more rapid re-pricing than in previous cycles. Indeed, U.S. commercial property prices have fallen further—and faster—from their peak values this time around than even the much maligned single-family home market (see Exhibit 3).

A signal of just how much backlogged distressed property may be in the offing can be gleaned from delinquency rates for com-mercial mortgage backed securities (CMBS), which have shot up from less than 0.5% in late 2007 to to 6.1% in early 2010—an amount equal to $45 billion, according to data from Bar- clays and J.P. Morgan. With valuations off so sharply, overleveraged owners could be forced to sell assets near the market bottom. That means investors with new capital may be able to obtain at-tractive deals relative to historical norms on both the purchase price and the financing for such transactions.

exHIbIt 3: coMMercIAl PrIces doWn fAster, fArtHer tHAn resIdentIAl

Dec

-00

Dec

-01

Dec

-02

Dec

-03

Dec

-04

Dec

-05

Dec

-06

Dec

-07

Dec

-08

Dec

-09

Residential

Commercial

Inde

x

Down 33%

Down 46%

100

110

120

130

140

150

160

170

180

190

200

Source: J.P. Morgan, S&P/Case-Shiller, Moody’s CPPI

e Is for energyA further extension on the investment case for climate change involves the potential for harnessing new forms of energy. While consumption of fossil fuels such as coal and oil face increasingly strong growth headwinds due to government regu-lations and limits on production capacity, alternative energy consumption—including biomass, geothermal, solar and wind power—are expected to grow significantly over the next few decades, thanks in part to proactive government policies. By 2030, these and other renewable sources (excluding conven-tional hydro) should account for about 8% of total global power generation compared to just 2% in 2008, reflecting an average 8% annual growth rate, according to the latest forecasts from the International Energy Agency (see Exhibit 4).

Amid the drive for finding alternatives to fossil fuels, we see three key themes: energy diversity, energy efficiency and energy sustainability. In particular, the quest for new sources of energy offers the potential to ease dependence on fossil fuels, burn cleaner with fewer wasteful by-products and outlast current known energy reserves. Buttressed by government incentives, we see renewable energy as a high potential area for investors in infrastructure. Both Australia and the European Union, for instance, have set goals of achieving 20% of their respective energy needs from renewable sources by 2020. Although costs are currently higher for alternatives due to high

real Assets, real opportunity


exHIbIt 4: World PoWer generAtIon estIMAtes bY fuel tYPe, (tWH)

0

5,000

10,000

15,000

20,000

25,000

30,000

35,000

40,000

1990 2008 2015 2020 2025 2030

Tide and waveSolarGeothermalWindBiomassHydro

NuclearGasOilCoal

Source: IEA World Energy Outlook, December 2009

installment costs, we expect economies of scale and techno-logical progress to bring higher overall expenses more in line with those of fossil fuels.

f Is for inflationAn increasingly hot topic among investors is the risk of elevated rates of inflation, a condition under which real assets have historically outperformed other asset classes. Given the amount of fiscal economic stimulus and the U.S. Federal Reserve’s easy

monetary policy, we believe that inflationary risks are a valid cause for concern. Our view is that real assets—particularly dis-tressed real assets—offer an opportunity to counter that risk.

Inflation-proofing a portfolio can take many forms, but real assets tend to incorporate a number of characteristics that have potentially positive inflation sensitivity. First and fore-most, rising real asset reproduction and replacement costs (in terms of labor and materials) may provide long-term inflation protection for existing buildings and infrastructure. CRE, for example, could benefit from higher new rental rates as leases expire, automatic inflation-linked rent adjustments or increas-es in operating expenses passed through to tenants.

Likewise, infrastructure assets offer inflation protection through regulatory rate setting mechanisms and long-term concession agreements. Regulated utilities periodically go through regulatory reviews that allow positive real returns on equity by passing along operating cost increases as well as debt service since the capital structure is also regulated. For transportation-related assets such as toll roads, airports and seaports, concession agreements almost always link the rates and tariffs to inflation. What’s more, as a natural monopoly, an infrastructure asset usually benefits from a highly inelastic demand curve that is not very responsive to price hikes. As a result, the historical track record shows that infrastructure cash flows in the U.S. have generally tracked or exceeded the consumer price index across most sub-sectors (see Exhibit 5).

80

130

180

230

280

1986 1988 1990 1992 1994 1996 1998 2000 2002 2004 2006 2008

Recession Infrastructure average CPI

Toll roads

Airports

Seaports

Electric companies

Gas companies Water and sewer utilities

exHIbIt 5: IndIces of AnnuAl ebItdA for u.s. InfrAstructure sub-sectors AgAInst cPI, ‘86–’08

Source: J.P. Morgan, Factset, FAA, FHA, Maritime Administration and company websites

28 PortfolIo 2010

g Is for governmentThe global political tide has turned decisively interventionist in both fiscal and monetary policy. For investors in real assets, that may be a positive development in more ways than one. Looser monetary policy, as noted above, may result in higher rates of inflation. More directly, massive fiscal expenditure through subsidies and tax incentives has cleared a wider path for investments in core infrastructure and environmen-tally sustainable real estate development. To cite just a few examples, the Obama Administration’s budget and stimulus package devoted more than $189 billion to clean energy, clean technology and all things green. In addition, the American Re-covery and Reinvestment Act of 2009 extended investment tax credits eight years for solar power and three years for wind power. Moreover, renewable energy developers can receive up to a 30% outright grant in lieu of a tax credit. In the real estate sector, cities are imposing restrictive building codes and offering attractive incentives for LEED-certified properties in order to clean up their neighborhoods.

Beyond the shores of the U.S., the opportunities in real assets also abound. That is true nowhere more than in emerging markets, where pent-up demand for infrastructure may pro-vide entry points for private capital for many years—if not de-cades—to come. Asia, in particular, has become a magnet for infrastructure-related investment to the tune of an estimated $250 billion per year from 2006-2010, according to data from the Asian Development Bank, the Japan Bank for International Cooperation and the World Bank. China alone is projected to spend nearly half that region-wide total on its pressing needs for airports, power plants and other infrastructure.

Far from crowding out private investment, the influx of government funds in Asia may act as a catalyst for increased private sector involvement. One reason for this is that govern-ments in Asia have limited financial resources and face more stringent restrictions on their ability to raise debt on global markets. Moreover, governments in emerging economies often encourage foreign capital participation to access greater expertise and innovation than would otherwise be available. India, for one, expects three-quarters of its infrastructure in-vestment needs to come from the private sector. And in China, the government has mandated it would earmark only a quar-ter of the financing needed for infrastructure projects targeted in its recent recession-fighting stimulus package. Therefore,

we believe there are ample opportunities to provide growth capital to the platforms which own and develop infrastructure in Asia.

conclusionWhy own tangible assets today? We believe the reasons are increasingly self-evident due to the massive re-pricing that real assets markets have undergone over the past 18 months, coupled with the “game changers” identified previously. In our view, real assets offer the potential for attractive returns from both capital appreciation and income generation through rents. What’s more, tangible assets stand to benefit from ample growth potential once the global economy returns to a more normal growth pattern. From a portfolio construc-tion perspective, real assets may provide a solution to much needed diversification, inflation protection and long-term capital preservation goals. Most importantly many real assets such as real estate, ships and, in some cases, infrastructure, are “on sale” because there are so many “unnatural” owners (such as banks) who at some point must sell. Also, there are a select group of discriminating investors with the vision to see past short-term challenges and focus on the long-term value opportunities made available from the excesses of others. Pur-chasing high quality real assets at deep discounts to replace-ment cost is a prudent and profitable way to play the develop-ing global recovery while picking up some portfolio protection should inflation exceed current expectations.

real Assets, real opportunity


In 2008, globAl eQuItY MArkets declined sharp-ly and credit spreads blew out to historic wides. Investors found that there were few places to hide as correlations across asset classes trended toward “1.” It is not surpris-ing that investors have reacted by reducing allocations to

equities and increasing allocations to fixed income assets. But what was most different in this downturn involved how liquidity risk played out, driven by an unprecedented amount of de-lever-aging throughout the financial system. For many, this brought into question the merits of the much heralded “endowment model,” which seeks greater exposure to hedge funds and other alternative strategies. With 20/20 hindsight, was it a mistake to hold large allocations in alternative investments? Coming into year-end 2008, it certainly felt that way as investors experienced redemption queues in core real estate funds and hedge fund managers imposed gates and limited the amount available for redemption. These liquidity events occurred even as some diver-sified investors also became saddled with large unfunded private equity commitments.

sizing up AllocationsYet as we look ahead in 2010, many investors have kept their strategic allocations to alternatives very much intact. How does the negative experience for most investors in alternatives

Hedge funds: An Attractive Alternative for the Multi-cycle Investor by Jef f gel ler, C I O, G l o b a l M u l t i -As s e t G ro u p, A m e r i c a s

30 PortfolIo 2010

Hedge funds: An Attractive Alternative for the Multi-cycle Investor

nearly a year ago square with the positive stance that many of these same investors are taking today? The conclusion reached by many is that the lesson learned was less about the merits of the strategies they invested in and more about the size of their allocations in less liquid strategies. This increased awareness of liquidity risk is particularly true for investors in private equity as it affects their ability to fund capital commitments. The key questions today are: is a less liquid investment sized properly in the totality of a portfolio considering an investor’s liquidity needs? And, secondly, will the investment provide a rich enough premium over public markets to justify the increased liquidity risk? Investors who feel that they over-allocated and over-paid may lick their wounds, but they won’t abandon these strategies entirely because an undiversified and unhedged liquid beta-centric equity and/or credit investment has its own risks.

Alpha vs. betaAnother theme driving investors is how to achieve a better mix of alpha and beta. After the tremendous rebound in equity and credit market indices throughout 2009, beta may not deliver returns as handsomely in 2010 based on a historical regres-sion to the mean. Therefore, we believe that active managers who invest with more of an absolute return objective and who are more agnostic about benchmarks may be an option worth considering. In other words, if an investor wants exposure to emerging markets, he or she may seek to hire managers with track records indicating that they can provide better differen-tiation than an indexed strategy by, for example, identifying truly emerging markets and avoiding potentially “submerging” markets globally. Or, in the case of a fixed income strategy, an investor may choose to invest with managers who have dem-onstrated a high “hit ratio” for avoiding negative credit events. If one extrapolates on this theme of more alpha and less beta, an allocation to hedge funds is a natural extension because they represent the purest form of unconstrained active money management and maximum risk-adjusted returns (using tools such as shorting and leverage.) In our view, hedge funds are not—in and of themselves—an asset class. They are simply a way to access a subset of skill-based money managers in equity and credit strategies.

the ‘endowment Model’Looking at hedge funds in this way leads to a better under-standing of the reasoning behind the decision of many of the larger endowments to shift from “beta one” strategies1 to hedge funds, a process dating back some 15–20 years. Conceptually, the idea revolves around the notion that if an investor could identify, access, and appropriately combine a set of skilled active managers, then the expected outcome would be a higher compounded return over time through a more asymmetric return pattern than that provided by a purely beta-focused portfolio. In other words, top-ranked active fund managers in the alternatives space offer the potential for better capital protection in adverse markets and keeping pace with—or outperforming—their benchmark indices when market returns are generally positive. The objective lesson derived from the endowment model over the past two decades is that it is important to look at long- term results. In practice, this means that the focus should be on the track record through multiple market cycles instead of one-year performance snapshots, which may be misleading. And endowments have had the patience and persistence to identify hedge funds with multi-cyclic outperformance and to cultivate long-term, mutually rewarding relationships with top-ranked managers.

A Healing ProcessMany hedge fund managers “gated” their investors by placing limits on redemptions in 2008 and early 2009, which was a big area of disappointment for those invested in these strategies. The other factor that disillusioned investors was the generally poor returns from most hedge funds during a time of great dislocations and volatility in the markets. But did investors have realistic expectations in the first place? The average hedge fund manager was down about 21% in 2008, according to the HFR diversified FoF index. But as poor as that may seem, that did not “underperform” the major benchmark stock indices, which all were down over 40%. Some investors—usually those newer to hedge funds—expected their managers to defy the law of gravity. But hedge funds in aggregate cannot outper-form on a sustained basis when every major market gets crushed. Ultimately, all fund managers swim in the same pool.

1 “Beta one” strategies are those with 100% exposure to market volatility, such as long-only and 130/30 funds, as opposed to market neutral long-short hedge funds.


The real problem may have been in terms of these excessive expectations—and, perhaps, marketing. Should hedge funds ever have been introduced to people as a kind of turbo-charged “cash plus” alternative? Probably not. We believe it wisest to approach hedge funds as a semi-liquid asymmetric play that performs best over multiple cycles. Even so, as credit markets recovered and equity markets came off their lows, many gated hedge fund investors got their money back much quicker than anyone had predicted. The “healing process” has been twofold: First, it was important for investors who wanted to get out to be able to do so. That cleared the decks, so to speak. Second, hedge funds are no longer seen as “safe” substitutes for long-only strategies—something they have never been and should not have been viewed as being during their bullish heyday in the mid-2000s.

through the looking glassAnother outcome is that investors are demanding—and getting—better access to hedge fund managers and greater transparen-cy into overall operations. That usually involves a deeper under-standing of what’s going on in the portfolio, including things like risk exposures. The new rule is: no surprises. Hedge funds have to regain the trust of their investors, who are no longer lining up and begging managers to take their money. That may mean, for example, conference calls on a more frequent basis and acceptance of much stricter due diligence procedures. Simply stated, there is now a more level playing field between inves-tors and managers. The regulatory environment also is likely to get tougher on hedge funds in terms of registration and report-ing requirements. And lock-up terms could become looser in response to investors seeking improved liquidity. The days of a three-year lock with a one-year rolling lock-up thereafter are long gone. But we believe they won’t disappear entirely. That’s because they originated as a way to protect investors in a pooled vehicle from collectively suffering due to an arbitrary re-demption before an investment has matured. Therefore, a rea-sonable lock-up period is to be expected in funds—particularly credit strategies—in which investments may take up to three or four years to exploit fully. Fees are another area that may not come completely unhinged—at least not for top-quintile hedge funds—because investors pay for performance. That’s the dream of active money management—the smartest guys in the room

can pull a rabbit out of the hat. In fact, only very few can pull it off, but, in our view, these exceptions will be able to continue to charge a premium for their skill sets.

Maximizing opportunity setsWhile liquidity is a risk factor that investors cannot ignore, cool-er heads have prevailed and investors are focusing on getting the right mix of liquid, less liquid, and illiquid strategies instead of abandoning hedge funds and other alternative investments altogether. Indeed, as long as the Fed remains committed to keeping rates at historically low levels, we believe that inves-tors should not be “short” on beta, but rather that they should look for a better mix of alpha and beta. And to the extent that investors choose actively managed strategies, our view is that unconstrained active managers are best positioned to take advantage of superior risk-adjusted return opportunities and to manage the downside risk of left-tail events. More specifically, assuming an investor has not given up on active management, hedge funds should continue to play an essential role in a well- diversified portfolio. These limited partnership structures offer greater flexibility to vary net market risk, hedging levels and leverage which, we believe, will result in a more asymmetric return pattern than what can be realized by building a portfolio entirely with “beta-one” strategies.

32 PortfolIo 2010

THe Hedge fund IndustrY had to quickly evolve following the turmoil of 2008, driven by new demands from investors and regulators alike. If there had been a proverbial “Rip Van Winkle” of hedge funds who was able to sleep through the

tumult of the last twenty-four months, the media headlines and timbre of conversation he woke up to would have astounded him. Fees, transparency, double-blind credit insurance optionalities and a rogues’ gallery of hedge fund “bandits” led by a certain Bernard Madoff have transfigured the business. It’s a new world for serious hedge fund investors. The chummy, take-it-or-leave-it and too often opaque hedge fund industry of yore is gone, replaced by a more chaste, client-oriented and transparent modus operandi. The altered landscape underfoot means that only managers who are willing and able to adapt to change will thrive in this new environment.

Implementing high octane financial strategies unconstrained by limits imposed on beta-only strategies now requires a degree of agility and tact to respond effectively to rapidly evolving regulatory and marketplace circumstances. In the 12 months since the markets reached their collective nadir at the height of the crisis during the winter of 2008/09, the most astute hedge fund managers implemented considerable changes to their operations and made significant concessions to their clients. We believe the new circumstances in the hedge

Hedge funds: A brave new World by corey case, CO O a n d Co - H e a d o f J.P. M o rg a n A l t e r n at i v e As s e t M a n a g e m e nt


fund industry are conditioning a fundamental redesign of how managers and investors engage. At the same time, instead of walking away from hedge funds, savvy clients are availing themselves of attractive opportunities in emerging areas of the business such as the secondary market.

Pressure to reduce fees Will continue through 2010A tolerance for higher fees, along with an attraction to the po-tential for excess returns that ascend to “nose-bleed territory” in the double- or triple-digits, have traditionally distinguished the 3(c) (7) crowd from more conservative investors. On aver-age, hedge fund managers charge a 1%–2% management fee and a performance fee of 20%–25% of returns, subject to a high watermark and loss carryforward.1 A notable by-product of the financial meltdown of 2008/09 was the disconnect between highly compensated fund companies and the absolute returns generated on behalf of their investors. Our proximity to the industry led us to conclude at a relatively early stage that one consequence of the market dislocation would be a spike in the number of managers who cut fees to help ensure that they were properly aligned with investors. Indeed, in principle, we believe that management fees should be more about covering the costs of running the management company, and less about generating outsized profits for the principals. Performance fees, on the other hand, should reward managers for attractive re-turns, while at the same time treating investors fairly–especially those who stayed the course during the darkest days of 2008.

In fact, the response from hedge funds has ranged from drastic fee reductions to more nuanced fee structures for client service and performance. While a number of managers simply reduced their management fees (even as performance fees dropped) in 2009, additional measures to decrease or to keep underlying fees to a minimum included:

Incorporating or increasing a “hurdle rate” to calculate •performance fees

Charging lower fees on select asset pools, perhaps on •assets not as actively managed

1 Loss carryforward is where previous year’s losses are carried forward, and these losses must be offset by future performance before any performance fees can be charged. A high watermark is similar, and is the highest value that an investor previous experienced, in that the value must be exceeded before any new incentive fees can be accrued.

Instituting size or term based fee discounts•

Granting the current high watermark on new investments•

Negotiating a revenue share•

It remains to be seen how the various fee configurations are accepted and ultimately converted into established pricing norms, but the rapid response of the industry underscores the importance of the dynamic between managers and investors. Placing a premium on liquidity, for example, recognizes the marketplace’s need for access to cash to fulfill short-term obligations and the opportunistic disposition of funds. Distin-guishing between management styles, and charging accord-ingly, also introduces a dimension of the mutual fund industry’s pricing paradigm.

Emerging from the crisis period into the “new now” of invest-ment relationships, the negotiating power of the investor rela-tive to hedge fund managers appears to have become more balanced than had been the case in the recent past. More pro-saically, hedge fund managers are now tethered with a shorter leash to the desired outcomes of more investors. This may be particularly relevant as a greater number of institutional mar-ket segments test the hedge fund waters, particularly public funds, where fees and cost structures have taken center stage.

greater transparency Improves risk-Management PracticesFollowing the disclosure of the fraud committed by Bernard Madoff at the end of 2008, the demand for increased trans-parency into the investments held by hedge funds escalated exponentially. Needless to say, most investors and even many managers in the industry have viewed this as an overdue initiative. With opacity increasingly viewed as an anachronism, access to information and clarity regarding portfolio holdings and management activity are becoming more of a norm in today’s investment arena. With risk management at the top of the investors’ priority lists, the ability to negotiate for more information should result in vastly improved sharing of portfolio data and manager insight.

However, transparency does not decrease the need for a thorough review of the risk-based and operational “checks and

34 PortfolIo 2010

balances” implemented by—and imposed upon—a given hedge fund manager. We believe that increased transparency in many ways places a greater responsibility on investors to enhance their own due diligence efforts. One of the areas of keenest interest to investors is exposure via overlap or over-concentra-tion in specific positions, sectors, leverage and/or prime bro-kerage counterparties. This is a form of risk management that has long distinguished the most successful managers and, not surprisingly, a capability appreciated by the most experienced and demanding investors. Hedge fund-of-funds, in particular, need to be able to analyze this torrent of information in a ro-bust and technologically advanced way, which means increased risk management staff and technology expenditures. In our view, that should give those fund-of-funds with both scale and capital a competitive advantage in the marketplace.

Consultants also have stepped up their scrutiny. Our experience in 2009 suggests that consultants in the institutional market, for example, are more closely studying risk management pro-cesses, and more than ever questioning hedge fund managers pointedly in order to determine risk at all levels of the process. For investors, the focus on fund-of-funds look-through capabili-ties shines a brighter light on portfolio exposures and how their money is being managed in the context of a broader strategy. This, in turn, may raise the standard by which all managers are evaluated. For instance, best practices may dictate that opera-tional due diligence be conducted by seasoned professionals with specialized backgrounds, including in such fields as techni-cal operations, trading, legal affairs and accounting. Fraud, in the case of Madoff, trumped the “audited” statements that accompanied his filed reports and statements. So while a man-ager may purport to be “transparent” and report all his or her positions to investors, those positions can still be fraudulent. In our view, only top-notch checks and verification processes can mitigate the risk of investing in a fraud.

As a corollary to that improved portfolio transparency, access to hedge fund managers and principals has also become more of an imperative. Indeed, the Madoff model of obfuscation and restricted access did not appear to pass muster with any of the leading institutional programs. The new paradigm calls for pulling back the “purple curtain” and engaging in frank, two-way conversations between hedge fund managers and their core investors. For the successful hedge fund-of-fund complexes, it has long been standard practice to require regular qualita-tive discussions with a manager regarding their investments,

themes and implemented strategies. Ideally, that dialogue also includes key professionals such as traders, analysts, compli-ance officers and business administration managers. Finally, increased transparency can also mean transparency into the terms a manager offers other investors. In our view, this expanded democratization of the industry bodes well for the interest of the institutional marketplace.

changing of the gates: structure and termsAs the financial crisis of 2008 made abundantly clear, the redemption terms a manager offers investors, and how that manager structures his or her balance sheet (including the liabilities or leverage the manager takes) are critical to ensure the stability of a fund, especially in times of stress. But we be-lieve the terms that a manager offers should be consistent with the necessities of managing liquidity, and not simply as a means to keep investor assets in place for the benefit of the manager. Last year was a time of marked change in that respect. Many managers, acknowledging investors’ evolving liquidity require-ments, adjusted their portfolio processes and strategies. Gated strategies were evaluated and modified to accommodate the exigencies of the marketplace. Examples of some of the changes made by managers in 2009 included:

Eliminating gates, increasing the percentage that can be •redeemed before a gate is triggered, and/or eliminating priority clauses in gates.2

Granting investors more flexibility to opt out of side pockets, •perhaps by creating non-side pocket share classes for any new investments, and, in several cases, allowing investors to transfer from their existing side pocket share classes to non-side pocket share classes.

Eliminating or decreasing the duration of a manager’s lock-•up to be more consistent with the liquidity of the assets managed. For instance, while a distressed credit manager may be able to justify a two-year lock-up given the illiquidity

Hedge funds: A brave new World

2 Priority clauses allow investors who were gated previously the priority to get out of the fund during subsequent redemption cycles, ahead of investors who were not previously gated. Unfortunately, such a clause can create a “run on the bank” scenario, where investors submit redemptions to ensure that they are po-sitioned in the priority category, if they anticipate that the manager will receive redemption requests that approach the gate percentage.


of the assets and the time it takes to take a company through a bankruptcy process, an equity long/short manager who invests in predominantly large capitalization stocks should not need one, or if he or she does it should not be too long in duration.

Increasing the redemption frequency (e.g., from semi- •annually to quarterly).

Reducing the number of days notice required before a •redemption could be processed.

Finding an optimal alignment of interests remains a priority for the near future, for both hedge fund managers and their investors. Managers need to strike a balance between offering investors liquidity terms that are too generous—which can put all investors at greater risk—and being overly restrictive. Find-ing this balance may force a hedge fund manager to engage with the marketplace in a new and unfamiliar role. Indeed, it bears noting that such engagement often is not an expertise of hedge fund managers. In some cases, the advice they receive in this regard from their counsel may even be flawed, putting an additional legal burden on the investor.

secondary Market As institutions with allocations to hedge funds sought liquid-ity coming into 2009, some investors found opportunities to purchase shares of select hedge funds at a discount in the secondary market. Many of the shares sold were held under a lock-up, gate, or under terms where redemptions were allowed only infrequently. In several cases, shares were offered in hedge funds that suspended redemptions or issued liquidating vehicles, as many managers did during the peak of the crisis. This presented what we believe to have been a “once in a blue moon” entry point for long-term investors, with typical dis-counts ranging from 10% to 30%.

The breadth and reach of the analytics applied during that type of opportunity evaluation suggests a checklist for the future. Hedge fund-of-funds managers, investors and consultants need to be able to recognize a good deal when they see it through their deep knowledge of product structure, terms and contingencies. Each transaction requires a different level of negotiation and execution effort, at times including negotiating with both the seller of the hedge fund shares for an attractive

discount, as well as with the hedge fund manager to allow for a change in beneficial owner and the preservation of embedded high watermarks and liquidity seasoning (e.g., avoiding the re-setting of lock-ups, etc.) From our perspective, we believe that as liquidity gradually returns to most markets, the volume of secondary transactions will likely decrease in 2010, as will the discounts to NAV where these shares trade.

redefining Hedge fundsThe survival of the fittest—in all senses of the term—is the subtext for the recent wake-up call to the hedge fund industry. Those capable of doing so have adroitly adjusted and adapted to the new ethos. And the drumbeat of change continues, threatening to leave hedge fund managers who have failed to come to terms with this shift in the zeitgeist even further be-hind. The industry as a whole continues to transform, acquiring a tighter protocol for engaging with sub-advisors, managing re-lationships with investors and deploying stricter, more thorough analytics and oversight.

The hedge fund of this decade will become, at some level, a product of the inevitable process of maturation of what most financial industry observers would agree is still a nascent asset management sector. No doubt hedge funds have been forced to embrace an accelerated rate of “maturity” following the events of 2008. But we believe the industry’s surviving players are generally stronger and better positioned to deal with market stress, as well as—importantly—being more aligned with the interest of their investors. What’s more, there is less competi-tion as weaker hedge fund managers have folded and many proprietary trading desks have been downsized, which should allow existing managers to benefit (e.g., from less crowding in positions, etc.) Regulators are watching the industry closely, and their discussions on how best to mitigate systemic risks will further reshape the financial system and capital markets in the months and years to come. Hopefully, that will help prevent an-other repeat of the events of 2008, which would be a welcome development for all investors, hedge funds included. Finally, it is worth noting that hedge fund managers are less levered than they were immediately prior to the credit crisis. Clearly, they are much more keenly aware of the risks of leverage (including counterparty risk) than ever before. We believe all of this bodes well for the future of hedge funds and is a reflection of the industry’s ability to adapt during uncertain times.

36 PortfolIo 2010

This document is intended solely to report on various investment views held by senior leaders at J.P. Morgan Asset Management. The views described herein do not necessarily represent the views held by J.P. Morgan Asset Management or its affiliates. Assumptions or claims made in some cases were based on proprietary research which may or may not have been verified. The research report has been created for educational use only. It should not be relied on to make investment decision. Opinions, estimates, forecasts, and statements of financial market trends are based on past and current market conditions, constitute the judgment of the preparer and are subject to change without notice. The information provided here is believed to have come from reliable sources but should not be assumed to be accurate or complete. The views and strategies described may not be suitable for all investors. References to specific securities, asset classes and financial markets are for illustrative purposes only and are not intended to be, and should not be interpreted as, recommendations.

The value of investments (equity, fixed income, real estate hedge fund, private equity) and the income from them will fluctuate and your investment is not guaranteed. Please note current performance may be higher or lower than the performance data shown. Please note that investments in foreign markets are subject to special currency, political, and economic risks. Exchange rates may cause the value of underlying overseas investments to go down or up. Investments in emerging markets may be more volatile than other markets and the risk to your capital is therefore greater. Also, the economic and political situations may be more volatile than in established economies and these may adversely influence the value of investments made.

All case studies are shown for illustrative purposes only and should not be relied upon as advice or interpreted as a recommendation. Results shown are not meant to be representative of actual investment results. Any securities mentioned throughout the presentation are shown for illustrative purposes only and should not be interpreted as recommendations to buy or sell. A full list of firm recommendations for the past year is available upon request.

J.P. Morgan Asset Management is the marketing name for the asset management business of J.P. Morgan Chase & Co. Those businesses include, but are not limited to, J.P. Morgan Investment Management Inc., Security Capital Research & Management Incorporated and J.P. Morgan Alternative Asset Management, Inc.

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