Written by: Yazann Romahi, Chief Investment Officer of Quantitative Beta Strategies and Lead Portfolio Manager of JPMorgan Diversified Return International Equity ETF at J.P. Morgan Asset Management
With investment returns around the world declining, investors have increasingly been looking beyond traditional asset classes to diversify their existing portfolios and to potentially pick up incremental returns. That’s where the potential of alternatives comes in. Once only available to institutional investors, alternative strategies are becoming more mainstream and accessible to individual investors through more cost efficient and liquid vehicles, such as mutual funds and exchange-traded funds.
A new take on diversification
Alternative strategies are a very important source of diversification in investor portfolios. A typical balanced investor can look at investments such as alternatives in two different ways:
- First, as a return-enhancing diversifier where traditional diversifiers may no longer be effective. For example, an investor could reduce exposure to low-risk assets such as fixed income, which has historically been a diversifier of choice. We believe that going forward, fixed income’s ability to diversify and deliver attractive returns is likely to be diminished given rising rates and low yields. Therefore, replacing some fixed income exposure with alternatives allows for increased diversification and potentially enhanced returns at a similar level of risk.
- Second, as a risk diversifier. Reducing one’s equity exposure to allocate to alternatives can help mitigate overall portfolio risk – and, just as important, drawdowns – while achieving an enhanced Sharpe ratio, or risk-adjusted return.
The chart below illustrates how alternatives (as represented by a broad hedge fund index) work. Historically, when the stock market was up, hedge fund strategies captured 44% of the upside. But when the market was down, hedge funds participated to a lesser degree. Similarly, when bonds performed well, hedge funds captured much of the upside; when bonds were down, hedge funds were actually slightly up.
Alternative beta: A rules-based approach
Alternative beta is a new category that allows investors to access the systematic components of hedge fund returns. In other words, it provides a rules-based approach to capturing various hedge fund styles, in contrast to active hedge fund strategies. Because they are rules-based, these types of strategies can enable investors to access the same type of returns in a more transparent, and consequently cost-efficient, fashion than was historically the case.
More specifically, the rules-based approach to capturing hedge fund styles is referred to as hedge fund beta. It should be noted that this is very different from what are referred to as hedge fund replication approaches. Hedge fund replication approaches tend to be top-down, regression-based analysis that is fundamentally backward-looking. Alternative beta, on the other hand, is bottom-up, investing in the same way as a hedge fund – by going long or short individual securities in a systematic fashion.
Risk management is core to the investment process. In a strategy designed to act as a diversifier to traditional asset classes, it is important to continuously monitor incidental or idiosyncratic risk, which refers to the risk that is uncorrelated to the overall market risk, such as company specific risk. For example, the investment team monitors market beta, sector beta and duration on a daily basis and adjusts when necessary.
This is the approach we take in managing the JPMorgan Diversified Alternatives ETF (JPHF). The Fund provides hedge fund exposure by diversifying across three hedge fund strategies: equity long/short, event-driven and global macro strategies.
JPHF: A diversified approach to hedge fund exposure
JPHF’s allocations across the equity long/short, event-driven and global macro strategies are dynamic and reflect the opportunity within each strategy. Over a market cycle, each strategy is designed to contribute an equal amount of risk to the overall portfolio. However, at any one point in time, these risks can differ substantially from the equal risk case.
For example, the event driven strategy’s allocation is based on the number of opportunities (events) identified. The strategy may have a lower allocation at times when there are simply not many merger deals going on between companies; the fewer the deals, the more limited opportunity there is for an event-driven strategy like merger arbitrage.
Each of these strategies has its own set of dynamics and the strength of the whole comes from diversification benefits across several levels – within the strategies themselves, within the Fund and within an investor’s overall portfolio level.
Implementing JPHF for investor portfolios
JPHF can be used as a core diversifier to a traditional portfolio. Investors seeking enhanced returns at a similar level of risk to their bond portfolios may want to fund an investment in JPHF from their fixed income allocation. Alternatively, investors seeking enhanced risk-adjusted returns, but less risk – and, crucially – improved drawdown characteristics, may want to fund an investment in JPHF from their equity allocation.
Looking for an alternative to enhance diversification in your portfolio?
For investors looking to further diversify their overall portfolio, JPMorgan Diversified Alternatives ETF (JPHF) seeks to increase diversification and reduce overall portfolio volatility through direct, diversified exposure to hedge fund strategies using a bottom-up, rules-based approach.
Learn more about JPHF and hear from our investment experts on June 22. Register for the webcast here.
Opinions and statements of market trends that are based on current market conditions constitute our judgment and are subject to change without notice. These views 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. Past performance is no guarantee of future results. Investment returns and principal value of an investment will fluctuate so that an investor’s shares, when sold or redeemed, may be worth more or less than their original cost. ETF shares are bought and sold throughout the day on an exchange at market price (not NAV) through a brokerage account, and are not individually redeemed from the fund. Shares may only be sold or redeemed directly from a fund by Authorized Participants, in very large creation/redemption units. For all products, brokerage commissions will reduce returns.
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