FOR INSTITUTIONAL/WHOLESALE/PROFESSIONAL CLIENTS AND QUALIFIED INVESTORS ONLY – NOT FOR RETAIL USE OR DISTRIBUTION
INVESTMENT
INVESTMENT
INSIGHTS
INSIGHTS
PORTFOLIO DISCUSSION
GLOBAL INSUR A NCE SOLUTIONS
Plausible Alternatives
December 2014
IN BRIEF
Connecting you with
our global network of
investment professionals
Alternative investments seem in many respects to constitute, for lack of a better term,
the best alternative for insurance portfolios today. They pursue idiosyncratic alpha in
an environment where the outlook for beta in traditional insurance investments seems
increasingly problematic:
• Much of alternatives’ return derives from their liquidity premium. Insurance
companies, with their relatively predictable cash flows and generally ample
liquid reserves, are well positioned to earn it.
• A small allocation to alternatives can deliver large diversification benefits to
portfolios heavily concentrated in investment grade fixed income.
• Aside from directly contributing to capital surplus, an alternatives allocation can
give shareholders in publicly traded companies indirect access to cutting-edge
investment strategies and managers.
Capitalizing on alternatives’ potential, however, demands a recognition of alpha’s
constantly evolving nature and disciplined due diligence that identifies those managers
most skilled at capturing it. Consistently and patiently applied, such due diligence can
drive returns well above a company’s cost of capital. Less rigorously executed, it can
expose the insurance investor to the underperformance always implicit in the pursuit of
high alpha.
Douglas Niemann
Through favorable and adverse investment climates,
alternative investments—hedge funds, real assets and
private equity—have consistently boosted insurers’
portfolio income and portfolio yields (Exhibit 1).1
Managing Director
Global Insurance Solutions
Alternative investments have enhanced portfolio yields
AUTHORS
Matthew Malloy
Managing Director
Global Insurance Solutions
Mark Snyder
EXHIBIT 1: SCHEDULE ALTERNATIVE INVESTMENT YIELDS VS. PORTFOLIO AVERAGE
14
Managing Director
Global Insurance Solutions
Gareth Haslip
Ping Li
Life BA yield
P&C average yield
P&C BA yield
10
Yield (%)
Executive Director
Global Insurance Solutions
Life average yield
12
8
6
Associate
Global Insurance Solutions
4
Declan Canavan
2
Managing Director
Alternatives Investment Strategies
0
2004
2005
2006
2007
2008
2009
2010
2011
2012
2013
Source: J.P. Morgan, SNL Financial; data as of December 31, 2013.
1
We define yield (income) here as statutory earned income divided by total assets, including both affiliated
and unaffiliated assets in the numerator and denominator. Alternative investment yields refers to
published BA yield for US insurers.
INVESTMENT
INSIGHTS
Such “alternatives” to more traditional asset classes have proven
a reliable resource—and on occasion have provided a critical
hedge. The 2005 spike in property and casualty (P&C) Schedule
BA yields2 presumably helped offset record catastrophe claims,
so that the sector ended that year with an extraordinarily low
financial impairment ratio (Exhibit 2).
Alternative investments recovered after the financial crisis...
Overall, alternatives have recovered rapidly since the financial
crisis, thanks to appreciation as well as additional allocations.
(Exhibits 3A and 3B). Among both life and P&C insurers, they
account for a greater proportion of unaffiliated assets today
(Exhibit 3C).3
Investment ($bn)
Plausible Alternatives
• How much is enough? That is, how can insurers tap into
alternatives’ superior return potential without compromising
their risk budgets?
• Is it worth the trade-off? Can the returns that insurers gain
from alternatives compensate for the liquidity they lose?
• Hunting alpha vs. gathering beta: How can insurers reliably
tap into the idiosyncratic sources of return that set alternative
investments apart?
80
Hedge fund
Private equity
Real estate
Other LPs
Sch BA fixed income/loans
Total
70
60
50
40
30
20
10
0
2008
2009
2010
2011
2012
2013
Source: J.P. Morgan, SNL Financial; data as of December 31, 2013.
EXHIBIT 3B: P&C INSURANCE—SCHEDULE BA UNAFFILIATED
ALTERNATIVE ASSET INVESTMENTS
35
Hedge fund
Private equity
Real estate
Other LPs
Sch BA fixed income/loans
Total
30
Investment ($bn)
This paper seeks to begin the process of defining more precisely
alternatives’ strategic function. It addresses four considerations
that underpin the case for alternative investing:
EXHIBIT 3A: LIFE INSURANCE—SCHEDULE BA UNAFFILIATED
ALTERNATIVE ASSET INVESTMENTS
• Overcoming the fee hurdle: How can the industry reconcile
the benefits of alpha with the high fees associated with it?
25
20
15
10
5
0
2008
2009
2010
2011
2012
2013
Yield spike in 2005 likely helped P&C insurers overcome year’s
record catastrophe points
Source: J.P. Morgan, SNL Financial; data as of December 31, 2013.
EXHIBIT 2: U.S. PROPERTY & CASUALTY—FINANCIAL IMPAIRMENT
FREQUENCY VS. CATASTROPHE POINTS IN COMBINED RATIO (1977–2012)
...and account for a greater percentage of insurance investment
than before the crisis
9/11
2005
hurricanes
16
14
Northridge
12
1.2
10
1.0
8
0.8
6
0.6
4
0.4
2010
2007
2004
2001
1998
1995
1992
1989
1986
0
1983
0.0
1980
0.2
2
Source: A.M. Best data and research, BestLink—Best’s Statement File—P/C US; data
as of December 31, 2012. (Losses prior to 2008 from ISO’s Property Claims Services.)
EXHIBIT 3C: SCHEDULE BA UNAFFILIATED ALTERNATIVE ASSETS AS A
PERCENTAGE OF TOTAL PORTFOLIO
Alternative investments/unaffiliated assets (%)
1.6
1.4
1977
Financial impairment frequency (%)
1.8
Andrew
Hugo
Catastrophe points in combined ratio
P&C FIF %
Catastrophe
points
2.0
Life
P&C
3.0
2.5
2.0
1.5
1.0
0.5
0.0
2008
2009
2010
2011
2012
2013
Source: J.P. Morgan, SNL Financial; data as of December 31, 2013.
2
3
US Insurers classify Alternative Investment yields as BA yields.
The reported numbers may understate total holdings, because many insurers invest in alternatives at the holding company level. Nor do they reflect the concentration
of alternative investments among insurers. A.M. Best’s “Trend Review” of June 30, 2014, reported that the five largest life insurance investors accounted for 51.5% of
the sector’s total investment in alternatives. P&C investments are even more concentrated: The top five companies in the sector hold 68.6% of the total. Even
eliminating Berkshire Hathaway, the top five still accounted for 48.8%. Alternative investment yields refers to published BA yield for US insurers.
2 | Plausible Alternatives
By way of definition
THE RIGHT FIT IN A NUTSHELL
Across the insurance industry—and even, we suspect, within
individual companies—no common standard defines alternative
investments. In this paper we define them as hedge funds, real
assets—both real estate and infrastructure—and private equity.
The investments themselves span traditional asset classifications,
but we have grouped them together on the basis of their
regulatory treatment and their fundamentals. US Insurers classify
them as illiquid Schedule BA assets. More fundamentally, they
share a risk factor and primary source of return that set them
apart from their traditional peers.
In their fundamentals and structures, alternative investments
align well with the insurance model.
• A little goes a long way: Because most insurance company
investment portfolios have a naturally concentrated position
in investment grade fixed income, it takes only a relatively
small alternatives allocation to move the return dial.
• A built-in safety brake: Regulatory capital charges impose a
limit on downside exposure.
• Cash flow compatibility: The structure of alternative investment
short-term capital calls and long-term distributions coincides
with the structure of policyholder premiums and payouts.
• Alternative investments can have an accounting advantage as
they typically mark to model.
The bulk of traditional return and volatility derives from moves in
the larger markets in which the investments participate—their
market beta, in other words. Alternatives, by contrast, seek to
add to return (or subtract from volatility) with idiosyncratic, often
proprietary factors identified or developed by their managers—
known as their unique alpha. They might realize their gain from
the information asymmetries found in esoteric or undeveloped
markets or from trades that exploit transient anomalies in
established markets.
Historically, a relatively small investment in alternatives has had a
disproportionate effect on insurance portfolio returns. Regulation
and the industry’s fiduciary responsibilities have joined to
concentrate insurance investments in the least volatile and most
liquid asset classes. So an incremental allocation to illiquid assets
like alternatives may consume an outsized portion of an insurer’s
total adjusted capital—capital available to cover unexpected
losses—but it can also deliver comparably large diversification
benefits and a hefty premium for liquidity (Exhibit 4).
A business argument reinforces the logical argument of
complementing a liquid portfolio core with an allocation to
illiquid alternatives. Many alternative investments generate much
of their alpha over lengthy holding periods. With their long-dated
liabilities, life insurers in particular have an institutional capacity
for the patience required for an investment of that nature to pay
off. The long view gives them the flexibility to rebalance
alternatives distributions according to market conditions, creating
a steady source of value over time. Moreover, by consistently
investing surplus premium income through rising and volatile
markets, alternatives’ good years can offset the bad.
• Exclusive shareholder benefits: Not only can an alternatives
allocation enhance insurers’ ability to pay policyholder claims
over the long term, it can give shareholders indirect exposure
to cutting-edge strategies and managers they could not otherwise access.
Alternatives’ outsized share of total adjusted capital puts a
regulatory floor under their downside
EXHIBIT 4: SCHEDULE BA UNAFFILIATED ALTERNATIVE ASSETS AS A
PERCENTAGE OF TOTAL ADJUSTED CAPITAL
Life
P&C
2010
2011
25
Alternative investments/capital (%)
How much is enough?
• A P&C hedge: A long position in real estate and infrastructure
offsets the implicit short in a property insurer’s coverage of
policyholders’ insured real assets.
20
15
10
5
0
2008
2009
2012
2013
Source: J.P. Morgan, SNL Financial; data as of December 31, 2013.
This institutional form of the retail investor’s dollar cost
averaging—inter-temporal diversification, as some investors call
it—adds the diversifying dimension of time to diversification
across asset classes and risk factors.
It functions to smooth results, channeling higher expected
alternatives returns into a relatively consistent stream.
J.P. Morgan Asset Management | 3
INVESTMENT
INSIGHTS
Plausible Alternatives
Looking ahead with the aid of J.P. Morgan’s proprietary Longterm Capital Market Return Assumptions 2014, we can highlight
and quantify the risk-adjusted return potential that an
alternatives allocation can add to a general account portfolio.
Exhibit 5 compares three hypothetical efficient frontiers:4 a pure
fixed income portfolio of cash, Treasuries and investment grade
corporates; the same portfolio that reduces the fixed income
allocation to invest in a mix of large cap stocks, ranging up to
5%; and a third portfolio that adds a blend of alternatives to the
mix—hedge funds, private equity, private debt, real estate and
infrastructure.5
As Exhibit 5 shows, the addition of alternatives to the allocation
mix substantially increases the model portfolio’s expected riskadjusted returns. At a targeted return of about 4.5%, for
example, the portfolio diversified with a 6% allocation to
alternatives would have a projected volatility of 2.3%. At 3.8%,
the projected volatility of the portfolio diversified with equities
alone would be almost three-quarters more. For the pure fixed
income portfolio, it comes to nearly three times more.
Diversifying with a small allocation to alternatives, life and
health insurers can moderate increased capital charges
Diversifying the typical insurance portfolio, alternatives can shift
risk-adjusted returns decisively upward
EXHIBIT 5: EFFICIENT PORTFOLIO FRONTIERS, USING EQUILIBRIUM
RETURN ASSUMPTIONS
Fixed income
Fixed income+equities
Fixed income+equities+alternatives
6.0
Expected return (%)
5.5
5.0
4.5
4.0
% risk-based capital, post-diversification and tax
EXHIBIT 6: MARGINAL RISK-BASED CAPITAL CHARGES
BB bonds
B bonds
Private equity and hedge funds
8.0
7.0
6.0
5.0
4.0
3.0
2.0
1.0
0.0
0.0
0.5
1.0 1.5 2.0 2.5 3.0 3.5 4.0 4.5 5.0
Schedule BA incremental investment (% of total)
5.5
6.0
Source: J.P. Morgan, SNL Financial; data as of December 31, 2013.
3.5
3.0
0.0
2.0
4.0
6.0
Surplus volatility (%)*
8.0
10.0
Source: J.P. Morgan, Long-term Capital Market Return Assumptions 2014.
*Surplus volatility equals the expected volatility of the capital surplus after
matching portfolio assets to liabilities with a five-year duration.
The alternatives allocation combines the firm’s equilibrium longterm rate assumption, developed by our analysts for each
alternative strategy, to look past shorter-term deviations and plot
a return trend over a time horizon of 10 to 15 years. Drawn
entirely from the fixed income portion of the portfolio, the
alternatives allocation ranges up to 6%.
4
5
The efficient frontiers are based on assumptions and calculations using data
available to J.P. Morgan and in light of current market conditions and available
investment opportunities. They are intended for illustrative purposes only and
are subject to significant limitations. Under different liability, risk and capital
constraints, the optimal portfolios will clearly differ from the analysis
presented above for a notional insurance company.
See Appendix A for a breakdown of the allocation at each data point.
4 | Plausible Alternatives
So despite alternatives’ inherent volatility—and thanks to the
added diversification they bring—their risk-adjusted return
potential can actually moderate overall portfolio risk, a fact also
reflected in incremental capital charges (Exhibit 6). The dotted
line in the exhibit represents the incremental regulatory capital
charges for an allocation of hedge funds and private equity,
ranging up to 6% of a typical insurance company’s total
investment portfolio. The solid lines represent capital charges for
high yield bonds. At moderate levels, as the allocation shifts
away from B and BB bonds toward alternatives, the capital
charges levied against the alternatives enjoy an incremental cost
advantage—up to a 2% allocation compared with the charges
assessed on BB bonds. The advantage persists up to 4.5% vs.
lower-rated B bonds.
The trade-off: liquidity in the balance
Likewise, the stresses of the hurricane year of 2005, and 2013, in
the aftermath of Superstorm Sandy, did not challenge robust P&C
liquidity.7 Even as they maintain this liquidity cushion, however, a
persistent low yield environment challenges public companies to
preserve their dividend, and a rallying stock market raises
expectations that they will increase it.8
Liquidity is the public insurance company’s proverbial doubleedged sword. For the policyholder, the risk lies in not having
enough; for the shareholder, it lies in having too much. Following
the credit crisis, the balance of liquidity shifted toward
policyholders. Life insurers and P&C companies have provisioned
in excess of the most extreme annuity redemptions and
catastrophic losses in recent history. The Geneva Association, an
industry think tank, reports that life insurers remained cash flow
positive despite the surrenders occasioned by the financial crisis.6
Exhibits 7A and 7B show how an allocation to alternatives would
have served in the past to meet conflicting stakeholder demands
by simultaneously smoothing and boosting the investment
earnings trajectory.
An alternatives allocation would have had a smoothing effect on long-term GAAP earnings
EXHIBIT 7A: U.S. P&C GAAP EARNINGS, HISTORICAL AND ADDING HISTORICAL RETURNS OF A 5% ALTERNATIVES ALLOCATION
Alternatives
5
Net income
Total
4
Quarterly income ($bn)
3
2
1
0
-1
-2
2013Q3
2013Q4
2013Q3
2013Q4
2013Q1
2013Q2
2013Q2
2012Q3
2012Q4
2012Q1
2012Q2
2011Q3
2011Q4
2011Q1
2011Q2
2010Q4
2010Q2
2010Q3
2010Q1
2009Q3
2009Q4
2009Q1
2009Q2
2008Q4
2008Q2
2008Q3
2008Q1
2007Q3
2007Q4
2007Q1
2007Q2
2006Q3
2006Q4
2006Q1
2006Q2
2005Q3
2005Q4
2005Q1
2005Q2
2004Q3
2004Q4
2004Q1
2004Q2
-3
-4
Source: J.P. Morgan, SNL Financial; data as of December 31, 2013.
Hypothetical P&C alternatives allocation: private equity 40%, hedge funds 50%, real estate 5%, infrastructure 5%
2013Q1
2012Q3
2012Q4
2012Q1
2012Q2
2011Q3
2011Q4
2011Q2
2011Q1
2010Q4
2010Q3
2010Q1
2010Q2
2009Q3
2009Q4
2009Q2
2009Q1
2008Q4
2008Q3
2008Q1
2008Q2
2007Q3
2007Q4
2007Q1
2007Q2
2006Q3
2006Q4
2006Q1
2006Q2
2005Q3
2005Q4
2005Q1
2005Q2
2004Q3
2004Q4
2004Q1
2004Q2
Quarterly income ($bn)
EXHIBIT 7B: U.S. LIFE AND HEALTH GAAP EARNINGS, HISTORICAL AND ADDING HISTORICAL RETURNS OF A 3% ALTERNATIVES ALLOCATION
8
Alternatives
Net income
Total
7
6
5
4
3
2
1
0
-1
-2
-3
-4
Source: J.P. Morgan, SNL Financial; data as of December 31, 2013.
Hypothetical life and health alternatives allocation: private equity 70%, hedge funds 20%, real estate 5%, infrastructure 5%
Sample includes all insurers in SNL’s GAAP filings database with consistently minimal allocation to alternatives over the last 10 years—a total of 14 P&C and eight life
and health companies.
7
8
International Association for the Study of Insurance Economics (Geneva
Association), “Surrenders in the Life Insurance Industry and Their Impact on
Liquidity” (August 2012): page 22.
6
Douglas Niemann. “Making the most of ‘interesting times’ in the bond
markets,” J.P. Morgan, April 2014.
It is worth noting that an alternatives allocation can address a public insurer’s
responsibility to its individual shareholders in yet another way.
A company’s decision to invest with a top manager affords them indirect
exposure to otherwise inaccessible alpha.
J.P. Morgan Asset Management | 5
Plausible Alternatives
The exhibits track actual GAAP earnings, compiled by SNL
Financial, for the two insurance sectors over the 40 quarters
beginning with the first quarter of 2004 and ending with the
fourth quarter of 2013. Property and casualty insurers reported
negative GAAP income in five of those quarters and life insurers in
three. We then modeled results using the historical quarterly
returns plus a small alternatives allocation diversified as before:
5% for the P&C sector and 3% for life insurers with their larger
balance sheets.9 In 14 out of a total of 80 reporting quarters,
alternative returns in one sector or the other would have detracted
from overall results. Alternatives would have enhanced results in
better than four of five reporting periods, in other words.
Alternatives would also have smoothed the overall record for P&C,
reducing the number of losing quarters from five to four.
Alternatives’ performance in extreme events is more mixed in the
case of life insurers. In the credit crisis, our hypothetical allocation
would have lifted returns into positive territory in two out of the
three negative quarters, but it would have driven positive returns
into negative territory in two quarters and added to losses in a
third. Our alternatives allocation would have detracted as well
during the outbreak of rate volatility in 2011.
Hunting vs. gathering
Conventional investment results tend to converge on a
benchmark mean as investors pile into a successful strategy and
arbitrage away the competitive edge. Over the last decade, for
example, top quartile long-only equity funds outperformed the
median manager by 0.7% to 2.3% per year.10 By contrast,
idiosyncratic, often proprietary alternative investment results
tend to diverge (Exhibit 8).11
The tendency has several important implications. Median returns
in alternative investing mean less, and track records count for
more. A recent study by consultants at McKinsey & Company
found that private equity returns in a given vintage year have
ranged from 50% for the top managers down to -30% for those
at the bottom.12
9
10
11
In fact, the Schedule BA allocations over the period averaged 7% for the P&C
sector and 3% for life insurers, with their typically larger portfolios. We
adjusted the allocations downward to eliminate the Schedule BA assets that we
excluded from our analysis: private loans and master limited partnerships.
Morningstar US OE Large Blend category, as of December 31, 2013.
See Appendix B for an explanation of the methodologies used to determine
expected manager dispersion.
6 | Plausible Alternatives
More than anything else, the wide dispersion of manager returns
characterizes alternative investments
EXHIBIT 8: EXPECTED LONG-TERM DISPERSION OF MANAGER RETURNS
25
Top quartile
Median
2014 equilibrium assumption
Bottom quartile
20
15
Return (%)
INVESTMENT
INSIGHTS
10
5
5.25
6.00
7.75
4.50
4.75
5.00
6.00
6.5
-0
-5
-10
Equity
hedged
Event Diversified Macro
driven
Relative
value
PE/
Buyout
U.S. Long-only
equity
real
estate
funds
Source: J.P. Morgan, Long-term Capital Market Return Assumptions 2014. See
Appendix B for methodology and sources used in determining manager dispersions.
The dispersion stands to reason—successful managers see the
more promising deals and accumulate more experience in
judging their merits. In private equity’s earlier days, the majority
of top quartile funds sustained their top quartile performance.
McKinsey observes that the persistence has declined since 2000,
as it has among alternatives managers generally. More
competition, better competition and, in private equity, subtler
ways of creating value beyond cut-and-paste financial
engineering all help explain the trend.
The same factors also point to the need for state-of-the-art due
diligence capabilities. A thorough understanding of what portions
of manager performance to attribute to luck, to skill and to
process, as essential as that is, no longer suffices. Effective due
diligence today calls for a well-reasoned, exhaustively researched
view of how a manager’s process will fare in a constantly shifting
dynamic of opportunity.
12
Sacha Ghai, Conor Kehoe and Gary Pinkus. Private equity: Changing
perceptions and new realities. McKinsey & Company, 2014.
A question of quartiles
Caveat venator: hunter beware
Exhibit 9 takes a closer look at the hypothetical blended fixed
income-equity-alternatives efficient frontier diagrammed in
Exhibit 5. It shows a range of expected long-term gross returns
for the top and bottom quartile alternative asset managers,
derived from our equilibrium assumption (the middle line, which
we posit as the median manager return) and based on our
experience with return dispersions. The allocation, to the same
group of alternatives as in Exhibit 5, varies somewhat from the
6% median.13 For the top quartile, it starts at 4.7%, rises to 5.9%
at the second data point and to 6% thereafter. For the bottom, it
drops to 5.5% at the last data point.
So the compelling potential of alternative investments for the
insurance investor comes packaged with a warning label: The
potential is compelling only for the top managers. Indeed,
effective alternative investing adds a fourth leg to the classic
strategic triangle. Besides the three basics of sound traditional
investing—formulating a coherent strategy, diversifying effectively
through the business cycle and rebalancing rigorously—adding
alternative assets to an insurance portfolio requires access to the
top managers. Contrary to conventional wisdom that holds that
the supply of attractive deals is the limiting factor in alternative
investing, we have found that the supply of capable managers is.
A dynamic economy will always generate attractive deals, and
their sources will always vary. The ability to hunt down the
attractive deals and the foresight to recognize them will always
be the scarce resource.
At lower levels of targeted return, we expect dramatically
reduced volatility. At a 4.4% total portfolio return target,
annualized volatility for portfolios with the top alternatives
managers should run about 0.9%. We estimate the median would
experience 2.3% volatility and a portfolio with bottom quartile
investments might undergo more than three-and-a-half times the
volatility of the portfolio with the top alternatives managers.
Aiming for the highest return with a maximum 6% allocation to
alternatives, the top quartile manager could attain a 5.8% return,
compared with a 5.6% median and 5.2% for a bottom quartile
manager. The real difference comes in the volatility expected to
attain those returns: 5.7% for the top, 8.1% for the medium and
7.6% for the bottom quartiles (for which, remember, our model
optimizer pared back the alternatives allocation to 5.5%).
Managers exercise a decisive influence on expected
alternatives returns
EXHIBIT 9: EFFICIENT PORTFOLIO FRONTIERS WITH ALTERNATIVE ASSETS:
EQUILIBRIUM FORECAST, TOP AND BOTTOM QUARTILE MANAGERS 14
Equilibrium
Top quartile
Bottom quartile
6.0
Expected return (%)
5.5
5.0
4.5
4.0
3.5
3.0
0.0
2.0
4.0
6.0
Surplus volatility (%)
8.0
10.0
Alpha’s ephemeral nature further complicates the search for it.
Alpha depends not only on manager ability but on how that
ability coincides with market opportunity and macroeconomic
circumstance. That lends a decidedly tactical character to
alternative investments as a strategic asset class. Alternative
investments don’t lend themselves to “set it and forget it”
oversight. Optimizing the allocation not only calls for an
approach sensitive to the global economy and markets and aware
of their likely portfolio impact, it also requires an informed view
of the most capable managers across the broad alternatives
spectrum. The insurance rating agencies, among others,
recognize the complexities. A.M. Best has stated that “although
management fees may be higher using a fund-of-funds approach,
it may be more cost effective … than trying to build this
capability in house,” and it does not penalize companies for
outsourcing alternative investing expertise.15
Insurance companies enjoy the advantages of scale, credibility
and patience in the pursuit of management talent capable of
selecting, structuring and monitoring alternatives portfolios. They
can make investments big enough to matter. Their reputation as
long-term institutional investors enhances a manager’s credibility
and leverage in the deal-making universe. Not least important,
insurers have a compatible time horizon: As noted, their ability to
capitalize on liquidity premiums and inter-temporal
diversification gives them a cash flow that parallels that of
alternative investments.
Source: J.P. Morgan Long-term Capital Market Return Assumptions 2014.
13
14
See Appendix C for a breakdown of the allocation at each data point.
See page 4, footnote 3 for further detail on our efficient frontier calculation.
15
A.M. Best. “Best’s Special Report: Trend Review 2014.”
J.P. Morgan Asset Management | 7
INVESTMENT
INSIGHTS
Plausible Alternatives
Overcoming the last hurdle: fees
Insurance companies can command the attention of the best
alternatives managers, but they have limited influence on their
fees. As in any endeavor where talent is the bottleneck—in
professional sports or the arts, for example—the best will forever
reap the benefits of excess demand. As long as alpha persists,
those who can capture it can charge essentially whatever the
traffic will bear. When it has eroded, fees come down and
managers seek other employment.
While investors have little control over what the best managers
charge, they can determine what they will pay. For an alternatives
allocation to benefit a general account portfolio, the expected
incremental return must exceed the company’s cost of capital,
multiplied by the incremental capital charge entailed in the
investment. Any other compensation arrangement is objectively
uneconomic. Assume, for instance, that an insurer’s weighted
average cost of capital is 10%.16 In a simplified example, the
insurer invests €100 with a top quartile private equity fund
returning 20% annually, in conformance with its recent history. If
the fund charges the standard 2% management fee and the
insurer agrees to a performance fee of 20% of returns above
12%, the insurer will realize a return of €16.40 (Exhibit 10).
Assuming a 23% corporate tax rate, the after-tax return drops to
€12.67. Deducting the cost of capital as per the Solvency II capital
requirement for Type II equities which is applicable to
alternatives, leaves net returns of €7.02.
Applying the same formula to the median historical private
equity return presents a sharply contrasting picture—and
reinforces the importance of manager selection. The median
return, at 10%, comes to about half the top quartile return and
below the 12% target. Even sparing the incentive fee, the
insurer’s realized return shrinks to less than half that of the top
quartile manager’s: €8.00 compared with €16.40. After
subtracting taxes and the cost of the capital set aside from the
realized return, the investment with the median manager still
does more than achieve breakeven: €6.18 – €5.65 = €0.53. This
highlights the importance of selecting the a top quartile
alternatives manager.
Quantifying the value a top alternatives manager can add
EXHIBIT 10: HYPOTHETICAL RETURN ON A €100 ALTERNATIVES
INVESTMENT
Manager ranking
Top quartile
Median
Total return
20.00
10.00
Management fee
-2.00
-2.00
Performance fee
-1.60
0.00
Net return
16.40
8.00
Tax (@23%)
-3.73
-1.82
After-tax return
12.67
6.18
Capital required
-5.65
-5.65
Capital-adjusted net return
7.02
0.53
Source: J.P Morgan. For illustrative purposes only.
Management fee, performance fee, tax and cost of capital are based on
assumptions, which may differ materially from actual costs. The total returns are
for illustrative purposes only and are subject to significant limitations.
Conclusion: the right fit
Alternative investments appear in many respects to constitute,
for lack of a better term, the best alternative for insurance
portfolios today. Alternatives managers pursue idiosyncratic
alpha in an environment where the outlook for beta in traditional
insurance investments seems increasingly problematic. Though
alternatives are risky in themselves, the diversification that
comes from their pursuit of unconventional sources of return and
unique risk factors can actually moderate overall risk in the
typically concentrated insurance portfolio. Similarly, their markto-model structure can tamp down the volatility of mark-tomarket reporting. Perhaps most crucially, alternative investments
give insurers the means to take more complete advantage of
their own business model by capturing a premium both for the
excess liquidity in their investment portfolios and the relative
predictability of their liabilities.
The upside of alternative investment is clear, but it calls for
careful attention to the downside. Alpha itself is transient, and its
pursuit calls for superior manager skills and acute investor
vigilance. Capturing it consistently demands insight and flexibility.
Insurers have the resources to identify and retain the top talent
and the scale to spread their positions effectively across the
spectrum of alternatives. With discipline and methodical
persistence in finding and monitoring their investment partners,
they can make the most of their allocations.
16
8 | Plausible Alternatives
Most alternatives managers in our experience have hurdle rates in the
7%–9% range.
Appendix A: Model portfolio efficient frontiers
Using returns projected from J.P. Morgan’s Long-term Capital
Market Return Assumptions 2014, we developed efficient
frontiers for Exhibit 5, with the following allocations at each
data point. The efficient frontiers are based on assumptions
and calculations using data available to J.P. Morgan and in
light of current market conditions and available investment
opportunities. They are intended for illustrative purposes only
and are subject to significant limitations.
Fixed income, plus U.S. large cap equity (%)
Expected rtn.
3.6
3.8
4.0
4.2
4.4
Expected vol.
0.6
1.0
1.7
2.7
3.8
ALLOCATION
Cash
34.7
29.3
26.1
23.7
21.3
Treasury
65.3
69.0
69.1
54.9
39.2
Corporate
0.0
0.0
0.0
16.4
34.5
Hedge fund
0.0
0.0
0.0
0.0
0.0
Private equity
0.0
0.0
0.0
0.0
0.0
Loans
0.0
0.0
0.0
0.0
0.0
Equity
0.0
1.7
4.7
5.0
5.0
Real estate
0.0
0.0
0.0
0.0
0.0
Infrastructure
0.0
0.0
0.0
0.0
0.0
100.0
100.0
100.0
100.0
100.0
TOTAL ASSETS
Fixed income (%)
Fixed income, plus U.S. large cap equity, plus alternatives (%)
Expected rtn.
3.6
3.8
4.0
4.2
4.4
Expected rtn.
4.4
4.6
4.8
5.0
5.2
5.4
5.6
Expected vol.
0.6
1.4
2.7
3.9
5.1
Expected vol.
2.3
3.1
3.9
4.9
5.9
6.9
8.1
Cash
34.7
29.7
27.3
24.9
22.5
Treasury
65.3
60.4
44.7
29.0
13.3
Cash
Treasury
18.8
69.3
12.1
69.3
8.1
59.4
5.7
43.7
3.3
28.0
0.9
12.3
0.0
0.0
Corporate
0.0
9.9
28.0
46.1
64.2
Corporate
0.0
0.0
11.4
29.5
47.6
65.7
80.0
Hedge fund
0.0
0.0
0.0
0.0
0.0
Hedge fund
0.5
0.5
0.5
0.5
0.5
0.5
0.5
0.0
Private equity
0.5
0.5
0.5
0.5
0.5
0.5
3.8
ALLOCATION
ALLOCATION
Private equity
0.0
0.0
0.0
0.0
Loans
0.0
0.0
0.0
0.0
0.0
Loans
0.9
7.6
10.0
10.0
10.0
10.0
9.0
Equity
0.0
0.0
0.0
0.0
0.0
Equity
5.0
5.0
5.0
5.0
5.0
5.0
5.0
0.0
Real estate
0.5
0.5
0.5
0.5
0.5
0.5
0.5
Infrastructure
4.5
4.5
4.5
4.5
4.5
4.5
1.2
Real estate
Infrastructure
TOTAL ASSETS
0.0
0.0
0.0
0.0
0.0
0.0
0.0
0.0
0.0
100.0
100.0
100.0
100.0
100.0
TOTAL ASSETS
100.0 100.0 100.0 100.0 100.0 100.0 100.0
J.P. Morgan Asset Management | 9
INVESTMENT
INSIGHTS
Plausible Alternatives
Appendix B: Expected alternatives manager
return dispersion
Hedge fund manager returns are taken from Bloomberg and
internal J.P. Morgan databases. The historical range is given at
twenty-fifth, fiftieth and seventy-fifth percentiles using
annualized returns from July 2005 to June 2013, with the
exception of private equity data.
For historical private equity dispersion, Thomson Venture
Economics is used for the 10-year pooled horizon return data,
broken down by quartiles. Thomson Venture Economics private
equity 10-year pooled horizon return is calculated by pooling all
cash flows from a sample of funds over a 10-year time
period, along with the sample’s net asset value at the beginning
and ending points of the calculation. Based on this pooled series
of cash flows, the pooled internal rate of return (IRR) is
calculated. When reporting the 10-year pooled horizon return by
quartile, a fund’s quartile position would be based on where the
10 | Plausible Alternatives
fund’s cumulative IRR falls compared with funds with similar
primary market, vintage year and fund stage focus. Cash flows
of funds with similar quartiles would be pooled together to
find the 10-year pooled horizon return by quartile.
Value-added real estate dispersion is sourced from Preqin
data for the category value-added real estate funds from
vintage years of 2001 to 2008. The numbers show the average
IRR quartiles for the first and third quartiles, and the median
IRR across these vintage years.
Long-only funds projects the historical dispersion of the
Morningstar US OE Large Blend category from January 1,
2004, through December 31, 2013, onto J.P. Morgan’s
equilibrium equity returns.
Given the complex risk-reward trade-off in these assets, we
counsel clients to rely on judgment rather than quantitative
optimization approaches in setting strategic allocations to these
asset class strategies.
Appendix C: Alternatives manager efficient
frontiers
Starting with the equilibrium returns projected from J.P. Morgan’s
Long-term Capital Market Return Assumptions 2014 for a blended
portfolio of fixed income, large cap U.S. stocks and alternative
investments, we developed efficient frontiers in Exhibit 9 for the top
quartile percentile alternatives manager returns and the bottom
quartile percentile manager returns, with the following allocations
at each data point. The efficient frontiers are based on assumptions
and calculations using data available to J.P. Morgan and in light of
current market conditions and available investment opportunities.
They are intended for illustrative purposes only and are subject to
significant limitations.
Top quartile (%)
Expected rtn.
4.4
4.6
4.8
5.0
5.2
5.4
5.6
5.8
Expected vol.
0.9
1.0
1.5
2.1
2.9
3.7
4.7
5.7
Cash
26.1
24.9
23.0
19.9
13.5
8.6
6.2
3.8
Treasury
69.1
69.2
69.2
69.3
69.3
62.7
47.0
31.3
Corporate
0.0
0.0
0.0
0.0
0.0
7.6
25.7
43.8
Hedge fund
0.5
0.5
0.5
0.5
0.5
0.5
0.5
0.5
Private equity
0.5
0.5
0.5
0.5
0.5
0.5
0.5
0.5
10.0
ALLOCATION
Loans
0.0
0.0
0.0
0.0
6.1
10.0
10.0
Equity
0.0
0.0
1.7
4.8
5.0
5.0
5.0
5.0
Real estate
2.0
2.6
0.5
0.5
0.5
0.5
0.5
0.5
Infrastructure
TOTAL ASSETS
1.7
2.4
4.5
4.5
4.5
4.5
4.5
4.5
100.0
100.0
100.0
100.0
100.0
100.0
100.0
100.0
Bottom quartile (%)
Expected rtn.
4.4
4.6
4.8
5.0
5.2
Expected vol.
3.5
4.4
5.4
6.5
7.6
0.0
ALLOCATION
Cash
9.2
6.8
4.4
2.0
66.6
50.9
35.2
19.6
3.1
Corporate
3.1
21.2
39.3
57.4
76.4
Hedge fund
0.5
0.5
0.5
0.5
0.5
Treasury
Private equity
0.5
0.5
0.5
0.5
0.5
Loans
10.0
10.0
10.0
10.0
10.0
Equity
5.0
5.0
5.0
5.0
5.0
4.0
Real estate
4.5
4.5
4.5
4.5
Infrastructure
0.5
0.5
0.5
0.5
0.5
100.0
100.0
100.0
100.0
100.0
TOTAL ASSETS
J.P. Morgan Asset Management | 11
INVESTMENT
INSIGHTS
PORTFOLIOAlternatives
DISCUSSION: Title Copy Here
Plausible
NOT FOR RETAIL DISTRIBUTION: This communication has been prepared exclusively for Institutional/Wholesale Investors as well as Professional Clients as defined by
local laws and regulation.
The opinions, estimates, forecasts, and statements of financial markets expressed are those held by J.P. Morgan Asset Management at the time of going to print and are
subject to change. Reliance upon information in this material is at the sole discretion of the recipient. Any research in this document has been obtained and may have been
acted upon by J.P. Morgan Asset Management for its own purpose. 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 advice or a recommendation relating to the buying or selling of investments. Furthermore, this material does
not contain sufficient information to support an investment decision and the recipient should ensure that all relevant information is obtained before making any investment.
Forecasts contained herein are for illustrative purposes, may be based upon proprietary research and are developed through analysis of historical public data.
J.P. Morgan Asset Management is the brand for the asset management business of JPMorgan Chase & Co. and its affiliates worldwide. This communication may be issued
by the following entities: in the United Kingdom by JPMorgan Asset Management (UK) Limited; in other EU jurisdictions by JPMorgan Asset Management (Europe) S.à r.l.;
in Switzerland by J.P. Morgan (Suisse) SA; in Hong Kong+C94 by JF Asset Management Limited, or JPMorgan Funds (Asia) Limited, or JPMorgan Asset Management Real
Assets (Asia) Limited; in India by JPMorgan Asset Management India Private Limited; in Singapore by JPMorgan Asset Management (Singapore) Limited, or JPMorgan Asset
Management Real Assets (Singapore) Pte Ltd; in Australia by JPMorgan Asset Management (Australia) Limited ; in Taiwan by JPMorgan Asset Management (Taiwan) Limited
and JPMorgan Funds (Taiwan) Limited; in Brazil by Banco J.P. Morgan S.A.; in Canada by JPMorgan Asset Management (Canada) Inc., and in the United States by J.P. Morgan
Investment Management Inc., JPMorgan Distribution Services Inc., and J.P. Morgan Institutional Investments, Inc. member FINRA/SIPC.
270 Park Avenue, New York, NY 10017
© 2014 JPMorgan Chase & Co. | II_Plausible Alternatives
LV–JPM22372 | 11/14
FOR INSTITUTIONAL/WHOLESALE/PROFESSIONAL CLIENTS AND QUALIFIED INVESTORS ONLY – NOT FOR RETAIL USE OR DISTRIBUTION
jpmorganinstitutional.com