The future of ESG investing

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Kumar Panja: Hi everyone. My name is Kumar Panja and I run the capital advisory group for J.P. Morgan in EMEA. Welcome to our fourth podcast episode, our very first to be recorded in London. The focus of today's episode is on the application and future of ESG. That is environmental, social and governance factors. And we're going to focus it on the alternative space with special reference to hedge funds. And you'd be pleased to know that I won't be the only person doing this. I'm very excited to be joined on today's episode by two leaders in this space, first, Jason Mitchell, who's the co-head of Responsible Investment at Man Group plc. Welcome, Jason.

Jason Mitchell: Thank you. It's great to be here.

Kumar Panja: And Michael Weinberg, who's the Managing Director, Head of Hedge Funds and Alternative Alpha at APG Asset Management.

Michael Weinberg: Thank you. Pleasure to be here as well.

Kumar Panja: Okay, let's get started. Back in May of 2019, our consulting team conducted a hedge fund client survey on ESG. I'll give you this stat, 77% of managers said they didn't know or didn't think that ESG provided any alpha opportunities. Do you think there is alpha in ESG investing? Let's start with you, Jason.

Jason Mitchell: So I will definitely take the bait on that. I mean I would sort of counter with the question, how do we measure it? I mean have you seen anyone talk about this in terms of performance attribution, whether it's risk or factor attribution? And the answer is no, because there's a problem in terms of measuring this and it goes to this sort of question that I'm really stuck on right now , which is what is measurable is manageable. And we have not built the sophistication yet for a number of reasons in terms of being able to express whether a portfolio is producing alpha. That said we, we do talk about alpha, but it tends to be anecdotal. It tends to be about stock specific stories. The problem with that is as you raise that to a portfolio level or higher, it becomes less clear if it is. Now that said, I think we have to recognize that we're working with limited amounts of data between 8 and 12 years of as was data, unrevised data when traditionally in quantitative finance we're working with a hundred years plus of data, which gives us a lot of time series to work through different economic cycles and how the factors behave through that. To give you a sense, we've defined it, we've spent two years in a program working on developing an uncorrelated orthogonal factor. Again, we can't make a strong claim around performance, but on a go-forward basis, it provides a very interesting measure to look at attribution across portfolios and to the degree that ESG is driving that performance or not.

Kumar Panja: So if anyone tells me alpha in ESG, I should look at them with skepticism.

Jason Mitchell: Look, I think if anyone comes out and makes a strong claim around a dataset, a time series of between five and 10 years, you've got to look at them with a high degree of skepticism. You just can't make that claim.

Kumar Panja: Okay, thank you. Mike, over to you.

Michael Weinberg: Yeah. Firstly, I just have to mention the views that I'm expressing today are my own and my firm's not looking for new clients, but that aside, at our firm APG, we spend a great deal of time researching alpha and ESG investing. We don't have any hard evidence yet, but we believe there are signs of positive correlation between ESG implementation and potentially returns. Our view is that the more information one has, including ESG data, about a company or investment, it provides a higher resolution picture about that company and facilitates better decision making. In addition, we have a view that more than ever with the younger generations, they appreciate companies that are more aligned with ESG factors and therefore those companies will be in greater demand. And companies that are less aligned will similarly experience lesser demand from an investment perspective. Then our view is that that in turn leads to a lesser cost to capital for the more ESG friendly companies and a greater cost of capital for the less ESG friendly companies. So over the long term, we believe investors like ourselves should conceptually be able to achieve better returns from investing in the ESG leaders and avoiding or engaging with the laggards to improve them.

Kumar Panja: Okay. And what about the way you implement ESG factors and the quality of those factors? For example, do you use third party research and ratings in part of the decision making process?

Jason Mitchell: Yes, we use a wide amount of data. It might often sound like I'm negative

Kumar Panja: You're being realistic.

Jason Mitchell: It becomes an excuse though, the high degree of disagreement to sort of beat up the data providers. The reality is we work with a lot of them. There's a lot of domain expertise that we use there. I think what's interesting though is that what is often sold as ESG. When you actually look at the underlying factor exposure for whatever that is, it's a lot of stuff that doesn't look like ESG. It's often quality or size, because there's a transparency bias.

Michael Weinberg: Though the trend in quality of ESG data is improving, we believe that you shouldn't rely on a single data source for taking any of these sources at face value. It's important to validate the data and confirm that it's conceptually not illogical. Equally importantly, at APG, we use proprietary methods to identify industry leaders and laggards. And that's based on a confluence of third party data and our own data. Moreover, we supplement our quantitative data with qualitative data that's based on our long term dialogue with companies and stakeholders. So it's a mosaic and it really creates this integrated picture.

Jason Mitchell: I mean there's this monoculture out there right now that is overly reliant on maybe one data source or maybe a couple, but they're taking these scores at face value and not doing enough digging independently and creating something that's proprietary. So I think that firms that actually recognize that that needs to be done will be advantaged going forward.

Kumar Panja: Great. Okay. Well look, can we pivot to hedge funds in particular? And from the conversations that my group has with both managers and allocators, it seems to be that hedge funds are behind the curve, but we are starting to see glimmers of hope with managers making meaningful strides in the space. What is your view on where the industry is now and where you think it will be in five years, with regards to ESG?

Michael Weinberg: We're actively engaging fund managers to ensure they have an ESG policy in place. In fact, we will not invest with a manager that doesn't have an ESG policy in place. Then on top of that, we have an exclusion list which is publicly filed on one of our affiliated websites, with specific company names. Tobacco, cluster bombs and nuclear weapons are on the exclusion list. In addition, we have UNSDI and SDG targets and our funds are contributing to these targets. So that's all now. Five years from now, we think having an ESG policy will be the low bar, the must-have. Because to your point, many funds don't now. We will only invest with funds that do, but many don't. In our view, funds without an ESG policy will be unable to raise capital. The funds that will thrive will be at the cutting edge of developing and using environmental, social and governance data as part of their daily investment decision process. Managers will also be engaging the companies in their portfolio about how to improve their business by improving their ESG performance. So we think over the next five years, a lot will change for the better in this respect among the market.

Kumar Panja: Right. Jason, your firm has spent a lot of time investing on this. You've got a seat which actually specializes in this. Do you think there's a competitive advantage at the moment because you guys have put a lot of investment into that? Does a rising tide lift all boats?

Jason Mitchell: To some degree there might be a competitive advantage. I think to be honest it sort of reflects the reality. An interesting exercise that we've gone through is to look at a couple markets, let's say, Europe, Canada, Australia and the US. And take the top 50 allocators, and try and understand which of those top 50 have a strong preference for responsible investment. In Europe, we think roughly around 65-70% of those allocators have a strong preference to responsible investment. When you look at Canada, you find roughly around 55-60%. Australia is roughly 45-50% and the US is 16%. So I'm not surprised if particularly US hedge funds are less sensitive to this. And so if you're a manager in any one of these regions, it's a matter of self-preservation to be honest, and attrition. The other thing that I would say to go back to that point about is ESG process or a factor? I think process sells pretty well in the long-only world. Process is a harder sell when your fee structure is 2 and 20, right? And so when you pay for performance, you kind of want to understand that sort of alignment or what ESG means for it, right? I mean, from an attributional perspective, from a risk to exposure perspective. And I don't think, I'm speaking at the industry level, that that kind of sophistication has developed yet.

Michael Weinberg: We would say ESG investing is not a factor though because so much of it is so subjective. One person's ESG requirements and constraints may be entirely different than another person’s or organization's. And different people and organizations have different sensitivities. So, we would say it's probably not a factor in that respect.

Kumar Panja: We've gone way beyond this being a fad. And I know we've done that in the traditional space and not only but even in alternative space. I think it's no longer okay for managers to totally ignore this if they have aspirations to grow and capture more of that investor mindset going forward. Just staying on that vein within hedge funds and breaking it down by strategy, it appears again from our conversations with managers that equity centric funds, there's equity longshore, market neutral. They're more able to be active in ESG, or they can claim that they can implement ESG factors. But if you're macro, multi-asset, multi-strategy, perhaps credit less so. And that also breeds a stasis within some of those managers that don't need to be. It's difficult, so therefore they don't need to. What do they need to do to move forward incorporating ESG?

Michael Weinberg: There's no one-size-fits-all approach and no single standard that applies to macro funds or any a strategy for that matter in our view. For multi-strategy funds, they're easily are sensible ESG policies for the underlying sub strategies, right? Such as equities and credit. Our view is that including ESG factors is simply a component of robust investing. The first step is for the manager to source the data and the second step is to analyze the material issues for the region, sector or securities and then the manager may think about how to systematically incorporate those factors into their decision making. So it's really a process and part of a process. There is no one-size-fits-all answer.

Kumar Panja: But let's get into a bit more detail. So if you're a macro manager and you're sort of many rates heavy, what would you do?

Michael Weinberg: I perhaps won't address rates specifically, but what we could address is, the macro manager can look at the ESG factors of the countries that it's investing in, or the regions or the sectors. And obviously, there would be potentially both quantitative and qualitative data and analysis available on all of those parameters, both for the region, sectors, countries and other types of securities.

Kumar Panja: Okay. And Jason, I mean, you've incorporated this or incorporating this across the whole suite of Man products, but-

Jason Mitchell: Not the whole suite.

Kumar Panja: Not the whole suite yet, but, maybe at some point.

Jason Mitchell: Only because it touches on the point that I think you're heading towards-

Kumar Panja: Yes.

Jason Mitchell: Which is, there are areas, particularly equities as we know, and increased corporate fixed income, as well as corporate or sovereign debt. But there are areas, nontraditional areas that are just more difficult, particularly when you look at managed futures funds or commodities funds, for instance. There's a lot of qualitative information. You can look at companies and sort of their exposure to commodities in the same way that people look at sort of companies in their exposure to carbon or climate risk. And so there are ways you can do it, but it's not easy. It's much more difficult.

Kumar Panja: Okay, thanks Jason. I'm going to follow up on a couple of things you mentioned there. One is this interpretation of ESG investment, but also the reporting and the transparency because there is this growing concept of greenwashing, which we understand to be perhaps easily described as an over-representation of the so-called ESG or green credentials of an investment strategy. Mike, perhaps you can talk us through what you see the issues are with greenwashing and whether you agree with that, with that sort of definition of greenwashing.

Michael Weinberg: Yeah, I mean, we would say ESG investing isn't black and white and it's clearly a gray area. However, what it is it's a serious commitment to doing hard work and identifying the relevant ESG factors, doing the analysis, making conscious investment decisions. That's what's really important. And you have to ask the right questions and validate the answers that you get. So, if you require transparency, you discuss the dilemmas and you look beyond the labels, we believe greenwashing is quickly exposed.

Jason Mitchell: I think it's fascinating. Again, there is peak paranoia and suspicion around it across the industry. But one thing that's interesting about greenwashing is that it means a lot of different things to a lot of different people, right? I mean, there's no hard definition and right now we're seeing a lot of really interesting product development in this space. We're seeing certainly an urgency like never before, particularly with the EU sustainable finance package. We're finding policymakers try to solve for policy outcomes, i.e. funding, financing the just transition or the transition towards a lower carbon future.

Kumar Panja: Recognizing that the majority of listeners we think will be the allocated community managers as well as in general, the hedge fund ecosystem. What one observation on ESG would you leave the listener with? Mike, I'll start with you.

Michael Weinberg: We won't even speak to managers about investing if they don't have an ESG policy. They must have an ESG policy. It has to be something that they think about, that they care about, that's integral in their investment process. It's super crucial and important to us. We're longterm investors. We would like to make the world a better place, and we think this is one way to do that.

Kumar Panja: Thank you. That's very clear. Jason, what are your thoughts?

Jason Mitchell: Focus on the data. Explore it. Stay broad. Look for ways to apply your finance experience in alternative datasets, whether it's climate governance. And so I feel like it sort of circles back to that core line again, what's measurable is manageable. We need to get better at this to help allocators, to help, as managers, allocate to companies to be more efficient.

Kumar Panja: Okay. We could have talked for hours and hours on this, but this has been really good. Thank you so much Jason and Mike for sharing your views with us. For our listeners, if you have any comments or ideas to continue the ESG discussion, please do let us know by getting in touch with your usual J.P. Morgan capital advisory contact. Thanks for listening.

Kumar Panja: The views expressed in this podcast may not necessarily reflect the views of J.P. Morgan Chase and Company or its affiliates, collectively J.P. Morgan. This communication is provided for information purposes only. J.P. Morgan normally makes markets and trades as principal in securities, other financial products and other asset classes that may be discussed in this communication. For additional disclaimers and regulatory disclosures, please consult www.jpmorgan.com/country/US/en/salesandtradingdisclaimer. Thank you.

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A view from U.S. Public Pensions on alternative investments

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Danielle: Welcome, and thank you for joining us for our third podcast in our series. Today we're focused on public pensions investing in alternatives. I'm Danielle Call, a 14-year veteran of The Capital Advisory Group based in New York, responsible for coverage of our public pension investors. I'm joined by Laura Lincoln who is the Senior Portfolio Manager with Utah Retirement Systems and covers credit and fixed income strategies across the entire portfolio. I'm also joined by Jason Rector who is a senior analyst with the Wisconsin Investment Board and covers external strategies across asset classes and hedge funds and beta one portfolios. With that, I'll turn it over to Laura and Jason to give you a brief background on both of their firms.

Laura: Thanks Danielle. I'm Laura Lincoln. I joined Utah Retirement Systems a little more than ten years ago and we are currently a $33 billion pension fund. We represent all of the public employees in the state of Utah.

Jason: Thanks for having me, Danielle. SWIB is the eighth largest public pension plan in the country with over $122 billion in AUM. I've worked at SWIB for about five years now. We do have a significant allocation to alternatives, depending on how you want to define it, and private equity real estate and hedge funds.

Danielle: Sitting within a bank, we've certainly witnessed a shift away from banks taking risk onto their balance sheets. We've been hearing more talk about pensions becoming warehouses of risk. I'd love to sort of hear your take on opportunities that this feel this is creative for your portfolio as well as if you feel like you're actually getting paid for taking this risk.Jason:
Yes, I'll kick it off. This has been something we've spent a lot of time on our team and I think broadly at SWIB. Basically the thesis is that pensions, stable long term capital base are very attractive places to house some of the strategies that used to be on banks' balance sheets. The key evolution over the past, we'll call it ten years since the crisis, has been the sophistication of the investment programs at public pensions. The Canadians have really spear headed it. Some of us in the U.S. I think are coming up the curve as well, but as we get more sophistication, we're able to take some of these strategies in house and we're able to analyze some of these strategies externally with managers as well. I think we see two main areas of opportunity, if I were to bucket this category of assets, if you will, and that's for us to be a liquidity provider on an opportunistic basis and these are traditionally credit oriented strategies I'd say kind of specialty finance type of strategies that you could use kind of like a peer to peer lending as a high level example. I think what we're doing is, is quite different and more nuanced, but that's an example of something that as banks stepped away, as lending became tighter there was a need for another capital provider. And so, one example of where we've been doing that is funding spin outs. And so as talent has come out of, prop desks at banks, and that's happened, again, since the crisis, whether it's funding hedge fund strategies where that talent goes to or whether it's bringing that talent in house has been the other area where I think when we think about where we're trying to become warehousers of risk and trying to evolve. That's, that's how we're doing it.

Danielle: And Laura, would you agree with, with that investment opportunity as well?

Laura: Yeah, I would. I don't that we necessarily always think of it as becoming a warehouse of risk that no longer fits within banks or other types of institutions, but I think one thing that's really enabled us to participate in maybe more esoteric strategies or non-traditional strategies is that it's also become more common that the structure matches the liquidity, the duration of the assets. And I think that's been a huge development in terms of opening new investment categories for pension investors, and really other institutions who are very cognizant of, of avoiding asset liability mismatches.

Danielle: I think, you know, along those lines another conversation that comes up quite frequently, while we're speaking to a lot of the public pensions has been talk about managed accounts. I wouldn't necessarily say that we're seeing that many pensions, at this point implementing, but certainly a lot of questions being asked. A lot of work being done. Is this something that both of your institutions have taken a look at?

Jason: Sure. So I think the main trade off when we've spent a lot of time evaluating managed accounts. It's something that comes up continually. We do have managed accounts, within our long only, our beta one book of business we have large allocations with funds since we're able to get managed accounts with our equity managers or fixed income managers, however, those are fully funded. They're buying cash securities so, where we see the opportunity for managed accounts and what's intriguing, is the capital efficiency of hedge fund and alternative strategies, which means if it's a strategy that uses leverage like discretionary macro or relative value, that you can partially fund that and that's much more capital efficient for your balance sheet because you've freed up some cash to do something else with. The issue that we've continually come back to is the potential for adverse selection, in terms of the strategies that you would like to have a managed account with. And when we look at the portfolio that we've built, we'd have to turn over a significant portion of that portfolio if we were to go to a purely managed account platform.

Laura: Yeah, I, I agree. I think again, like Jason, we have managed accounts that are long only. We have a very small number of truly managed accounts, which are maybe in more non-traditional strategies but can't really be long-short because of our constraints around leverage. And so, managed account platforms are something that we have also explored as a possible solution for having more control over the assets themselves and having more visibility into liquidity and overlap across different funds. I think we've also struggled with the same issue that Jason mentioned, which is that you may have some element of either certain strategies not being a good fit for managed account platforms or some kind of adverse selection bias in terms of the managers that are willing to participate in a managed account platform.

Laura: So I think there are challenges to it. We haven't gotten comfortable with managed account platforms yet but it is something that we've spent a fair amount of time looking at.

Jason: There is a middle ground there too. Where maybe you use it for part of your program but you still keep the managers that won't do it. The issue that you run there is aside from capital efficiency, the main selling point for managed accounts is transparency and risk management and the ability to tweak the portfolio. When you can only do it on a subset of your portfolio it significantly hampers that benefit, which is, again, when we come back to it, it's like okay what's the capital efficiency benefit I can get from where I can do it, relative to the adverse selection. And so I think we continually come around to it and utilize it very selectively.

Danielle: I guess on that given the increase for transparency and fees being a big issues. I think we've been seeing more and more pensions managing assets internally. Do you think it provides a certain, you know, benefit to the plan?

Laura: I think it depends a lot on the resources that, that any given fund or team has available. So I think the way that we manage internally at the present time is that we try to get our equity beta from internally managed indexes, and that's a very cost efficient way for us to get that exposure rather than paying an external manager to do what we can effectively do in house. We don't have additional internally managed strategies at this time. We're really built around a manager diligence and fund selection model, in terms of our team’s expertise with the exception being our real estate portfolio, which is a direct portfolio. That's a very different skill set than managing a fixed income index in house, but should we continue to grow resource, we may be making a different choice down the road.

Jason: Yeah, and I think, I mean we're slightly larger but I, it's the same philosophy. We start out with, what do we want to do? What do we think the asset allocation and active risk allocation is that can help us achieve our objectives? Once we've decided what that is, then it's just let's be practical and let's be rational about the best way to implement that solution. And so, for us, once you do get a little more scale you start to really make the evolution into more of an asset manager type of organization. And so, I think the ideal organization, honestly, for doing what we do is a hybrid of that because we can do a lot of things internally, whether it's beta replication, which a lot of times we can do for very cheap. And now you've seen that evolve in recent years where we've built out an internal multi-asset team. We've continued to build out our internal active equity and fixed income teams. Where we don't need to do that as much externally whereas ten years ago it was, it was a very different category. And so, when we think about what that means for alternatives, I think it's a big deal. Because, go back five, ten years ago and hedge funds strategies that were in everybody's portfolio, are starting to make their way out of our portfolio.

Laura: Can I just ask?

Jason: Yeah.

Laura: Is that primarily sort of an alpha capture mentality that's where you're looking at strategies that are coming out of your portfolio? Is that because you just don't see significant out performance possibility at this time?

Jason: Yeah, I think there's a correlation there because one example, in our portfolio has been CTAs. And I think there are multiple reasons why we've brought, we still have some CTAs in, in our portfolio but it's the ones that our internal team also has a CTA? And so, what we think, what we're doing in CTAs within our hedge fund portfolio is very different than what our internal teams are doing.

Laura: Mm-hmm (affirmative).

Jason: I think there's a correlation between oh, once we figure out that we can do something internally it's saying something about what we want to be doing in our hedge fund portfolio as well as just in general. We probably want to be investing in the cracks. We want to be investing in places that are less crowded, less sophisticated because we think that we're going to get compensated for digging and doing the diligence.

Laura: Yeah.

Danielle: Given that rates have been so low for some time now, how has your fixed income allocation changed, if at all? Sort of in size as well as in composition.

Laura: So we have a fixed income allocation which is relatively small, right now we're at about 15% of our total plan assets in fixed income and that's almost all investment grade. There's one very small allocation that can be core plus. We have had quite a bit of cash for a while, which has been a bit of a drag. But I think right now, we're at a certainly a big discussion point for our team in terms of thinking about whether the AG exposure that we currently have is the exposure that we want to keep owning, given where rates are and given where the duration is on that bench mark. We haven't made any decisions yet but it's very topical for our team.

Jason: Yeah, I mean, we take a pretty long term approach to the total portfolio pension plans asset allocation. We have, I think roughly, 30% in fixed income. I don't think that's changed meaningfully. I don't expect it to. Where we are a little bit more variable in our hedge fund portfolio and in some of our private credit, our private debt portfolios, there's been a lot of conversation around okay, we're late cycle. Year after year high yield and corporate spreads keep coming in so we're making good money but we don't necessarily want to go to cash because there's opportunity costs to that. We've spent a lot of time, this goes back to becoming a warehouser for risk and trying to find different sources of carry, basically. And so, finding specialty finance is the one that comes to mind first, but finding some of these sources of return. They tend to have a distribution that resembles credit and so that's kind of why it fits nicely in that bucket.

Danielle: And it sounds like moving more down the to less liquid opportunities.

Jason: The liquidity is up to you but I think the complexity premium is real. Because for a lot of these things, you may not have a true loss curve that goes back more than you may not even have it going back to the crisis, which is problematic.

Laura: I think for us because our fixed income allocation is relatively small and it's also at the bottom end of its sort of strategic range right now. We want that piece of the portfolio to act as a source of liquidity, but right now I think the choice is sort of do we want something that's maybe like a short duration, high quality, almost like cash or cash plus, as opposed to taking the duration of the AG and not having a lot of upside at this point. So, for us it's really preserving liquidity and making sure we have dry powder if there, if we find opportunities to deploy it. We have a lot of less liquid strategies in the rest of our portfolio and that does include private credit and lending. It's interesting to talk about the specialty finance or different types of consumer lending or business lending strategies that are out there. And a lot of those have relatively short duration or time frame that they're actually outstanding. It leads you to another problem, which is reinvestment risk. So, yes, you may be capturing some premium for participating in that but if it's only outstanding for nine months or 18 months, then you've got to figure out what you're doing after that.

Jason: Yep, that's a fair point.

Danielle: The hot topic everyone wants to talk about these days is fees, right? I think there's been a lot of pushback on hedge fund fees and we've seen people get very creative. Texas Teachers has been very vocal with their 1 or 30 model. Are you seeing a big shift away from these higher fee products? Have you seen any, kind of creative fee structures? Have you adopted the 1 or 30 model?

Laura: For URS, this has been a hot topic for a long time. It's definitely not a new topic for us. I think we've been on the forefront of pushing not just fees but also structures that offer better alignment between the GP and the LP for a number of years really coming out of 2008 was when we really started pushing on that particular subject and ultimately, it is about reducing the fee load so that our beneficiaries are guaranteed the retirement that they're expecting. So that's our end goal, is to get the best performing strategies we can at a cost that is A) reasonable and B) aligned between us and, and the people deploying the capital. Actually, our former investment counsel now works at Albourne and has been very instrumental in the 1 or 30 model and really kind of getting that implemented across the board. I think that it can work very well. It really depends on the strategy. It is dependent on being able to identify some kind of beta or bench mark that you want to use, which isn't always particularly easy to do.

Jason: Yeah, I would just emphasize the focus for us, I mean we're proud of the level, but more importantly, the alignment of the fee structures that, that we’ve negotiated. I think if you looked across our hedge funds we've got custom fee deals with the vast majority. And in the situations where they're capacity constrained or have no reason to reduce fees we've been able to change the alignment, which may be like reducing a management fee and increasing an incentive fee or something like that. So that the managers, when we see them willing to do that when they don't have to, they're inherently betting on themselves. If you're too focused on the level of fees, or if you try and implement the same structure across all different strategies, you're going to end up making a type one or a type two error. You're going to let things go by that you otherwise shouldn't have and you're going to potentially compromise on quality too.

Laura: Yeah. I totally agree with that. I think you can't take a cookie cutter approach to fees, terms and structures, but it is also important to keep it simple, to keep it operationally efficient, and something that both the GP and us, as the LP can implement, we have certainly had the experience of maybe getting a bit too cute with the structure and having it be overly complicated to actually put into place. And then, in the end, making sure that you're first and foremost choosing thoughtful investors. Not just selecting based on who will take the business for the cheapest fee. Totally agree.

Danielle: Thank you for listening today. We hope you enjoyed that podcast. And thank you again to Jason and Laura for their participation.

Jason: Thank you.

Laura: Thanks a lot for the opportunity.

Danielle: The views in this podcast do not necessarily reflect the views of JPMorgan Chase and Co. or its affiliates. This communication is provided for information purposes only. JPMorgan Chase and Co. or its affiliates (collectively JPMorgan) normally make a market and trade as a principal and securities. Other financial products and other asset classes that may be discussed in this communication. For additional disclaimers and regulatory disclosures, Please consult. www.jpmorgan.com/country/us/en/salesandtradingdisclaimer.
 
 
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The evolution of the endowment model

Kenny King: Hi.  I am Kenny King and I lead JP Morgan’s Americas Capital Advisory Group.  During our first podcast episode, we discussed the role of hedge funds today.  In today’s episode, we will focus on the endowment model and how it has evolved over time. Our Capital Advisory Group speaks with over 180 endowments and foundations across the globe with an average of $5.6 billion in assets under management.  This is an important segment. Monica Issar, Global Head of JP Morgan Wealth Management’s Multi-Asset and Portfolio Solutions, will lead the discussion with Meredith Jenkins and Kim Lew.  Meredith is a chief investment officer for Trinity Wall Street and Kim is a vice-president and chief investment officer for Carnegie Corporation of New York. 

Kenny King: Welcome, everybody.  Monica, shall we kick off the discussion?

Monica: Thanks, Kenny.  Let’s start, actually, with defining the endowment model.  First and foremost, the endowment model needs to generate high-enough returns to take care of yearly withdrawals without dipping into principal. And then, the second aspect of it, really, is preserving the real value of its principal and taking care of inflation and these days, many of us have to focus on it more than ever before versus the past decade. So, speaking about it today, Meredith and Kim, we’re thrilled to have this conversation with you. Considering we’re at the later end of the cycle, one of the biggest questions that I know we’re all facing is a much more muted return environment.

Monica: And with that, you know, what are the strategies within the hedge fund space are you considering as you think about forward-looking returns, considering you both do have that distribution to focus on each and every year.

Meredith: Yeah, thanks, Monica.  Well, first I’ll give a little context because Trinity is a unique situation in that for the vast majority of our 300-plus years of history, our endowment was in direct real estate in downtown Manhattan and a decision was made in 2015, partly because it felt like the cycle had run for quite a while on the real estate side, to take some money off the table. And so, at that point in time, uh, we sold a stake in our real estate and that produced about $1.7 billion.  Today, when we look at our endowment, we have, uh, about $2.8 billion in the diversified part of the portfolio and we still have a remaining about $3 billion of exposure to direct real estate. So, we’re in a little bit of a unique situation

Monica: Right.
 

Meredith: Because it’s only been the past three years that we’ve had a diversified endowment.  Part of the reason we took money off the table on the real estate was to be thinking about, “Okay, how can we get to a stage where we have a much steadier annual budget?” and suspend more like a typical foundation, you know, that we can really rely on.  We can be strategic.  We can plan out over multiple years and so, that was a big piece of deciding to diversify and then, within that $2.8 billion, we think about, “Okay, what makes sense for diversification there?” As you introduced it, the endowment model, it’s a high bar to do all of that and so, I always think of kind of a secondary piece of the endowment model, because it is so difficult, is to think about what are your unique strengths and where do you have an edge so that you can do all of that. And so, we, we try to think about that, um, I would say Kim will probably have more interesting stuff that’s very direct for the current environment.  You know, we are still—because we’re in such early days

Monica: Sure.
 

Meredith: we’re still doing a lot of foundation-building and across the portfolio, looking at a variety of different opportunity sets in our portfolio, in particular, that we think will really add resilience to the portfolio by kind of zigging when the market is zagging

Monica: Sure.

Meredith: And having a different path in the market, but still over a cycle, an attractive path that we think produces the kinds of returns you need to produce a long-term spend.

Monica: So, repeatable, but less correlated

Meredith: Yes, exactly.

Monica: to maybe traditional markets.

Meredith: Exactly, exactly.

Monica: Kim, is that where you are doing most of—you and the team—doing most of the research on, on, uh, strategies because at this part of the cycle, everyone says, “Look.  I’m going to do 10% or 12% over a cycle.” We are now at the end of one cycle and probably like starting to think about what the next cycle looks like.  What types of strategies are you guys researching?

Kim: So, let me put Carnegie Corporation in context first.

Monica: Perfect

Kim: And give you a little sense of how we think about the endowment model because I think we embrace everything you just said and there are some nuances to it that I think that, um, is probably common among a lot of foundations, or perhaps a little different. So first, Carnegie is a $3.5 billion foundation—the oldest private foundation, in fact—got its first CIO in 1999 and so, has been building out that portfolio over the last 20 years. So, Meredith’s portfolio is where we were probably 15 years ago as opposed to where we are now, where we have a fully-constructed portfolio. I think the nuance, when we think about what the endowment model is, it is a way to leverage the fact that we have long-term asset and we can be somewhat benchmark-agnostic, right?  And so, when we think about what kind of strategies we look for, we look for strategies that leverage the fact that we can be patient capital. We don’t need to have every part of the portfolio perform every year.  So, to your, your point that we have to preserve the endowment, the part of the endowment we have to preserve is only $125 million.

Monica: That’s right.

Kim: Because that was the original gift from Andrew Carnegie.  Everything else is how the portfolio has grown and so, we have the, the ability to take a little bit of volatility and look through any one moment in time and yes, we’re all talking about the fact that we are late in the cycle right now.  We’ve been talking about the fact that we’re late in the cycle for about five years now.

Meredith: Exactly.

Kim: And so, it is thinking about that, not because we manage to any one point in the cycle, we manage the endowment over cycles, meaning we build a portfolio that we think, regardless of where we are there’s some part of the portfolio that will perform. You may make some tweaks to it because of where you think you are, but our asset allocation is a long-term asset allocation.

Monica: Right.

Kim: It doesn’t change that much, right?

Monica: Right.

Kim: The portfolio construction within the asset allocation changes, but not the asset allocation, and so, right now, when we’re thinking about the portfolio, we’re thinking about yes, we’re at a point where the equity markets maybe aren’t producing, or we fear that they won’t be producing the return that they have in the past and we have an equity-centric portfolio, so how do we think about it?  Okay, let’s think about things that are not necessarily tied to the equity market, but still have a lot of alpha and still perform well over the long term.  

Monica: I, I think that’s, that’s a really important point and I’m glad you brought it up and what a nice contrast of where you both are in terms of stewarding the ship of your organizations. One of the things, Kim, you mentioned was permanency of capital and I love that description because that really is what endowments and foundations to be one of the first types of institutional capital looking at—I’ll use the term “alternatives” right? So, what are the skill sets that you think about when you’re thinking about your staff and looking at idiosyncratic returns or we spoke a little bit about less-correlated assets.  Are there unique characteristics that you’re looking for in the people that you’re hiring on your teams?

Meredith: Yeah.  I think it’s a unique skill set.  You know, when, when we go out to identify managers, these are people who we’re going to partner with, we expect, for a long period of time when we decide to give them money and they’re out in the market every day for us and so, that, that’s a really important and powerful partnership. So, when I look for people who can do that, it’s not just a, um, they’re really good at, modeling and, smart as a whip.  That’s an element.  I want someone who’s smart and curious and, and excited about it, but it’s also they really like to meet people and they like to be students of people and how they work together as a team and whether there are kind of cracks in that, or whether there’s something really strong and durable and repeatable about that element because I think when you’re looking at these managers, a lot of times, the issues that they end up having are, they, they’re resonant in something that’s much more, interpersonal or emotional than they are in just math and…

Monica: That’s right and the qualitative is sometimes the most difficult, actually, to both teach, right…

Meredith: Um-hmm.

Monica: as well as cipher out from, from managers themselves.

Kim: And I think that’s why, right now, it is increasingly more important to have diverse teams, right?

Monica: Um-hmm.

Kim: The type of skills that you’re going to need in order to operate and out-perform in this environment are changing. The patterns were clearer before and I think the patterns are not as clear, so what you need is people who have seen a lot of different things and similarly, we look at our managers, we also want managers who have thought about that; who have thought about the market is not behaving exactly the way it has in the past.  It rhymes, but it’s not exactly the same.

Monica: That’s exactly right and that’s why I like nimbleness, flexibility, to your point about wider experiences.  I know one of the areas that we’ve been spending a lot of time on is healthcare. Healthcare used to be just understanding the science of, to your point about, you know, good at math and then, sort of lends yourself to be able to discern the quantitative elements of investing and I know we’ve been talking about healthcare an interesting sector.  Are there other sectors, or idiosyncratic return streams that are peaking your interest these days more than others?

Meredith: There’s so much going on

Monica: Yeah.

Meredith: sort of from an innovation perspective, the internet and TMT and so

Monica: Yep and we were talking about crypto currency earlier, yeah, right, right.

Meredith: Exactly and, and, I always feel like it’s hard for me to be an expert on all of that because my purview is so wide.

Monica: Sure.

Meredith: But to find managers who are really deep in one of those that I feel like, “Oh, that person is an expert and I can go to them,” and they’re so good at it that they can explain it in a way that, sort of anyone could get - to have those sorts of managers in our portfolio is great because it helps get us exposure to the, the wide variety of opportunities that we hope are all going to kind of perform differently in different environments.

Monica: That actually brings me to something that we’ve spending a lot of time on is key characteristics, like what are those signals that help us see who will be those managers that can continue to invest, right, to your point about will have that expertise these days, you need to be able to have much more firepower, and firepower used to be defined as people, right, and now, much more, it’s about data, systems, tools.  We talked about the repeatability of investment returns. Are there other key characteristics besides some of the qualitative elements we already talked about around hedge funds that you guys look at in terms of a partner?

Meredith: In terms of qualitative, one thing we always like to understand is sort of a self-awareness and kind of these are my strengths and these are my weaknesses and this is how I’m filling that in, either, the people on my team or data sources that will help me in some way, but sort of a keen awareness of the mistakes they’ve made along the way, what they’ve learned from them and self-awareness of this is what I’m good at and this is what I struggle with more and this is how I pull it all together.

Monica: Right and that transparency.

Meredith: Yeah, yeah.

Kim: I think, you know, despite the fact that the tools and the mechanisms we may use in order to out-perform are evolving, the core of how we select managers is still the same.  It’s are you aligned. Do you act like a partner?  Do you understand your market and can you explain it in a way that the layman can understand it because we are explaining this to our board, who are laymen, sometimes, in this.

Monica: Right.

Kim: It’s also when you think about the opportunity set, are you aware of when your opportunity will work and when it will not work?  And increasingly, have you built a business that is sustainable?  A lot of people are still focused on, “I just need to raise capital so I could get it done.” But no, you’re building a business, right, and your business has to be built to last because it’s really hard with small teams and the kind of portfolio construction that we have, to have a lot of people coming in and out of the portfolio. Typically the best investors are not necessarily the best at building businesses and they, and they introduce a lot of risk into that process.  We’re more likely to get burnt by a business risk than we are about an investment risk because there’s tons of things we can do to back-test for whether or not they’re good investors, but much harder to tell whether or not something is going to be introduced into the mix that’s going to make for a bad business.

Monica: It’s a really good point and you know, more and more, the stakes are higher and higher. One of the things that we often talk about is at this part of the cycle, with the mandates that endowments and foundations have, there still has to have that deliberate return that has to be high enough to take care of that yearly withdrawal, and understanding from managers, is really, really important because in other types of buying behaviors, you don’t necessarily need that draw each year and so, the permanency of the capital, that commitment is even more important as time goes on.
 

One of the things that all of us seem to still talk about even though it’s been 11 years, which is liquidity risk and many of us were having conversations around high yield towards the end of last year, but liquidity risk also comes up.  So, the trade-off of return and liquidity, as it pertains to, whether it’s hedge funds, private equity, real estate, you know, how do you all think about liquidity risk as you think about the portfolio construction, Kim, to your point, on the portfolio and maybe we start with you.
 

Kim: I think that it is, it is human for us to always solve for the last problem and the last problem that the foundation and endowment space had was liquidity.  We found out in 2008 that we did not have enough liquidity and so certain behaviors happened.  We all got line of credits.  We all increased our cash, or our fixed income exposure. We all thought about what our unfunded commitment looks like and that’s an important part of it.
 

Monica: Right.
 

Kim: Because what happened last time, there were fewer varieties of capital that were invested in alternatives and so, what happened was a lot of the foundations and endowments who invested in these alternatives said to our managers, “I need you not to call capital right now because we have a liquidity problem,” and so, that was a tool that was used.  Let’s just stop investing for a period of time and let us get our legs underneath us.  
 
Well, there’s a far more diverse space of capital out there now and some people will have plenty of resources and will not be happy about the decision to not invest, especially when the market dislocates, right, because we’re always looking for those moments when the market dislocates.
 
And so, it is about really controlling your unfunded. It is about having the ability to invest when the market declines, but we have more tools now than we used to have.  There are different ways to do that.  I think we probably over-solved for liquidity, but given the fact that we have no inflows of capital, like we haven’t gotten a new dollar since 1918, 1919, we’re not going to get any more money.  We have to be very conscious of that.  All foundations do, so it’s not that it is not an important thing. I don’t think that that’s going to be the problem that we have.  It will be something new.
 

Monica: Right.
 

Meredith: Yeah, and, but as, as Kim said, we don’t get new money in. Our endowment peers are, obviously, in a very different situation, but organizations that aren’t significant and regular capital-raisers, you have to be thoughtful about where’s your liquidity going to come from and the extent to which you’ve made commitments, either to your private equity managers, or more recently, you’ve seen hedge funds raise these opportunity funds to sit on the sideline when things get much more dislocated in a way, and that’s a real commitment that many of us and our peers have made, so you have to think about that liquidity that you have mentally tied up and have to have it ready.So, I do think one of the good things that came out of the crisis was much of a focus on liquidity and understanding these are the commitments we’ve made in the portfolio, this is what our annual spend needs are and we do need to focus on that more and think about it.  Okay, so what are the tools?  Do we plan in ways to use futures?  Do we plan on having a line-of-credit that will be there so that we don’t have to sell when everything’s down and, and we have the liquidity to do really interesting things when the market dislocates. You never know what it’s going to look like, obviously, when that happens.
 

Monica: That’s right, yeah.
 

Meredith: And so, it’ll be interesting to see how it turns out.
 

Monica: But patience and compounding, right?  We often all talk about once you make those commitments, having the patience to go through the cycle, as well as how powerful that compounding can be to meet those overall, long-term returns, right?
 

Meredith: You know, and it’s, it’s going to be about bravery, right?
 

Monica: Um-hmm.
 

Meredith: Because people who even had liquidity were hesitant to invest when prices were good because people didn’t know whether we were at the bottom.  And so, there’s a little bit of not just having liquidity, but having the courage to use the liquidity that you have and I think that that’s going to be something that’s going to be interesting to see how people respond. It’s, it’s one of the things that we spend a lot of time looking at.  Our hedge fund managers, how have they performed when things were rocky, right?
 

Monica: Um-hmm.
 

Meredith: Were they able to be brave?  Were they able to invest capital when there were dislocations? How convicted were they in their portfolio and a lot of times that’s what you see; that you don’t see that they’re able to be brave at the right time, or reallocate capital in down markets.  And so we’re spending a lot of time looking at that, too.
 
Monica: And that’s when we need them to, right?
 
Meredith: Um-hmm.
 
Monica: That’s, that’s when you need to think about the skill sets, the qualitative elements, not just how they’ve done historically, but in those dislocations, do they stay true to their investment strategy or not, right, and so…
 
Meredith: And that’s a very qualitative assessment.
 

Monica: Yeah.
 

Meredith: You know, it’s the, those questions of, so what do you do when the chips are down, you know?
 

Meredith and Kim, thank you so much for this discussion this morning.  It was really terrific to get your insights and how you both are thinking about stewarding your institutions as fiduciaries.  As you said, this is a really important role that we all play in, in pretty challenging markets and uh, today’s discussion was just terrific.  Thank you.
 

Kim: Thank you.
 

Meredith: Thank you, Monica.
 

Kenny King: That was a great discussion.  Thank you, Monica, Meredith and Kim for your time today.  
 

Kenny King: We look forward to hosting our next guests and hope you enjoyed tuning into this podcast episode of the JP Morgan Capital Advisory Group miniseries.

Kenny King: The views in this podcast do not necessarily reflect the views of JP Morgan Chase or its affiliates.  This communication is provided for informational purposes only.  JP Morgan Chase or its affiliates, collectively JP Morgan, normally make a market and trade as principal in securities, other financial products and other asset classes that may be discussed in this communication. 
For additional disclaimers and regulatory disclosures, please consult the links in the, in the description.

This communication is provided for informational purposes only.  JP Morgan Chase or its affiliates, collectively JP Morgan, normally make a market and trade as principal in securities, other financial products and other asset classes that may be discussed in this communication. 
 

[END OF PODCAST]

What is the role of hedge funds today?

[MUSIC]

Julia Verlaine: Welcome to the first episode of our Capital Advisory Group’s podcast series, What is the role of Hedge Funds today? Following the results of our 2019 Institutional Investor Survey, Kenny King, Head of J.P. Morgan’s Americas Capital Advisory Group, dives deeper into the findings and discusses the trends we expect to see for Hedge Funds this year.

Kenny; Hello, listeners. My name is Kenny King. I'm the Americas head of the Capital Advisory Group. I'm thrilled to be with two of my good friends, Paul Zummo, Chief Investment Officer, J.P. Morgan, Alternative Asset Management, and Michael Gubenko, Global Head of Hedge Fund Due Diligence for J.P. Morgan, Global Wealth Management. Thank you both for being here for our inaugural podcast episode.

Michael: Thanks for having us, Kenny.

Paul: Thanks, Kenny. Great to be here.

Kenny: We recently released our annual investor survey, and even after a challenging 2018, investors remain committed to hedge funds. On the other hand, there's definitely frustration. Hedge funds had struggled to produce alpha, alpha being defined as beating a benchmark. Investors continue to believe that they're getting more beta, beta being defined as just getting the benchmark rather than getting a true source of alpha and a differentiated experience with their managers. Seventy percent of investors did not meet their target return, which has me, uh, scratching my head. What is the role of hedge funds today? Paul, Michael, how are your businesses thinking about the role of hedge funds in your portfolio?

Michael: you want me to kick off?

Paul: Sure. Why don't you start it off.

Michael: Alrighty. Look, I think that undoubtedly most investors who have been investing in hedge funds have been frustrated with the level of returns they've witnessed out of their portfolio for the past, you know, call it five to seven years as a whole. And I think some are starting to alter what their expectations are for it, and I think that's the exact, like, the wrong place to start here. And so, here's how we think about it within, uh, within wealth management. We use hedge funds as part of a multi asset class portfolio. We are responsible for managing people's wealth, uh, across generations, and so most of the money that we manage is in multi asset class solutions. And if you think about that, it's really we break it down into the basic building blocks, which are equities provide growth, fixed income provides stability, and then we've used hedge funds for diversification benefits. So, you know, one of the objectives that we always set for ourselves is, well, um, what is the beta that we expect to come from our hedge fund allocation? We manage our, our, our allocations to be anywhere between a 0.2 and a 0.3 beta to equity markets as a function of where we are, um, in a cycle, today being later cycle. And so, um, we look for a minimum of 200 basis points of alpha on top of that.

Paul: Yeah, I'd say that the vast majority of our clients are looking , uh, at hedge funds for a source of, of diversification to their other asset classes, but I'd say that, you know, that's not necessarily the case across the board. And maybe more broadly, the way we work with clients has become increasingly, and the solutions in which we provide, has become increasingly customized, increasingly bespoke, um, over the years as well.

Kenny: with the industry close to $3 trillion in assets, are you finding sourcing managers more challenging today than five years ago?

Michael: I would think for, I would think for both of us, right, you think about this industry, reached an all-time peak last year despite the way that you commenced this conversation about frustration, so clearly there's still money flowing into it. Um, and, you know, how many participants are there? North of 8,000, maybe even, like, 10,000, especially as, um, um, as you've seen growth outside of the core market of the US and even traditional Europe, right, into more emerging economies of the world. And so, both of us I think view this as we've got to find the best in breed that there is, and so, you know, the number of managers that we cover is well less than 1 percent cover, meaning, uh, invest in well less than 1 percent of that, that, that total universe.

Paul: Well, there's no, no shortage of, of managers. You know, there's always, uh, there's the difficulty of finding good managers, definitely you've seen alpha come down structurally over, you know, 10, 20 years, and especially in certain strategies. So, maybe just take, you know, a couple different areas. Um, like, fixed income replacement. So, as the prospect for rising rates was really on the mind of many investors, I think people were often turning toward hedge funds as a fixed income replacement, more kind of multi-strategy-oriented portfolio. And, you know, private credit would be another one. Uh, there's obviously many different forms of private credit. Um, on one hand the, you know, direct lending space is, is much more commoditized, but there's a lot of different, you know, substrategies within private credit that are less trafficked and, again, offer both higher rates of return and higher alpha potential. Um, volatility. So, uh, volatility obviously increased in the fourth quarter, but I think there was concern, just given the level of equity market valuations and a prospect for higher volatility, and that led toward, um, many more conversation around quantitative investments, specifically statistical arbitrage and specifically on the shorter term oftentimes machine learning-oriented statistical arbitrage, which is a beneficiary of a heightened volatility environment.

Kenny: We're definitely seeing, seeing an increased focus on quantitative strategies. Maybe you can define or tell us what are the key drivers because you've definitely been a big proponent of quantitative strategy.

Paul: Right. Yeah, I mean, you know, it's, it's, it's funny, depending on your experience in quant, you could kind of come away with very different conclusions. Or if you're reading the newspapers, you'd see, you know—I don't know, you'd open it up on Monday and it, it, it says quant did, did terribly. You know, Tuesday it's done great. You know, Thursday someone's going out of business. So, it, it, it's too large, you know, just to say quant, it's just too large of an area. you could really slice that quant world into a lot of different substrategies. I mean, commodity trading advisors on one hand, CTAs, risk, you know, risk-parity based things on, on another. Um, and they've performed quite differently, and even, you know, taking a space like statistical arbitrage, if you look at machine learning focused managers, they have actually performed, at least recently performed, much different than the traditional methodologies as well. So, growth in data is obviously enormous, both structured and unstructured data. The cost of computing power has obviously come down. That plays into the hands of new managers that are starting up, helping them compete. Um, obviously new techniques. You know, natural language processing, machine learning, all that is really, really important to generate new alpha signals and to be best of breed and to try to, you know, compete for a small manager and startup manager with some of the larger players. So, you know, we think it is definitely going to be increasing impactful on the hedge fund industry, and that's really exciting, um, but it's obviously affecting wider investment management world as well. And, you know, I'm sure we'll talk about long-short equities, but, you know, if you're a fundamental long-short equity manager and you're not evolving, and, you know, you really have to say how much alpha potential will be left, you know, looking out three, five, 10 years, given the competition that is, that is emerging in the machine learning space.
Kenny: Paul, you make a great point, though. Looking at our survey, quant is definitely the place people are looking to add where fundamental long-short definitely did not have its finest moment in the fourth quarter. Definitely feel like investors are definitely churning their portfolio in the fundamental long-short space. Michael, what are you seeing and doing?

Michael: Um, so, let's talk fundamental long-short for a minute. Um, where I started here is, is a function of where we are in the cycle, which we think is late cycle. We have been de-emphasizing, um, our strategies that contribute to that beta target that, uh, that we run. And so, that inevitably means that we've been, um, shrinking our exposure to both fundamental long-short and [venture], which a good percentage of the [venture] universe, given where they are today, um, given the lack of real distressed opportunities or dislocated credit is largely if you have the ability to invest across the capital structure, invested, uh, invested in equities.
And so, um, you know, I, We think that there is, um—there are pockets of really high-caliber people who have the ability to be generalist investors wherever they go, and then there's investors within long-short that also bring that specialization to bear. And there are sectors that, um—where you have a wider universe of stocks, more dispersion. Take tech and health care, to be exact. So, either that sector focus or regional focus we think is one that could lend itself to, uh, alpha potential

Kenny: Paul, it feels like [indiscernible] for alpha and long-short, people are looking east, you know, from the—looking to go to Asia. It feels like that's where—you know, I've been traveling the last two weeks, and it feels like every conversation I have with an allocator for pension, a family office, it feels like everyone wants to increase their Asia exposure.

Paul: Right.

Kenny: Do you think there's probably more inefficiencies in Asia which may allow for alpha?

Paul: Yeah, look, there's a number of things. Um, I mean, many of the Asian markets were even—sold off even more and obviously more bought quickly, so I think that's caught people's attention. Opened up China is, is, uh, is another one. The quality of—well, the quality of managers, though, is, is probably the most dominant one. You know, the quality of managers today versus five or 10 or 15 years ago has risen dramatically, and ultimately, you know, at the end of the day, you're going to take strategy views and market views to some degree, but it's really all about manager selection. So, I think people can get much more comfortable with the manager, uh, manager selection side. And then, yeah, you know, alpha should be higher there. Inefficiencies are higher. You don't get—arguably you don't get as much of the crowding as, as you do in, in other places, although, you know, it certainly exists there as well. So, for all those reasons, we've, you know, pretty consistently—and again, not that it's, it's a dominant piece of what we're doing in long-short. US is still the largest. But we've definitely incrementally done more and more in Asia.

Michael: I would say the only thing about that, like, if we're just focusing on the equity side of the equation, what we've generally seen—and no doubt that that market's become more institutionalized, but it also tends to run at—with higher nets than we see elsewhere throughout the world, right? Like, there's less discipline on the short side. It's been a market that trying to capture the beta, maybe not always structurally positioned that way but try and time it as well. And so, I think there's, there's, there's aspects of investing there that you'd have to be conscious of as you step into that market, too, which is it tends to be a higher beta market. They tend to lean longer. And so, to that—it contributes to that beta profile.

Kenny: We've talked about investing in APAC. How are you thinking about your exposure to European managers?

Kenny: I mean, Europe seems to have a lot of different, uh, issues. You're constantly hearing about Brexit and different, uh, nations, but it seems like that could be a potential source of opportunity.

Paul: I, I know Michael has the answer on Brexit. He knows exactly what's going to happen.

Michael: So, so Europe, um, let's start with it on the, on the equity side of the equation. Um, the number—we talked about the number of managers earlier on in this conversation. Number of managers in Europe structured as hedge funds has gone down meaningfully as a function of the fact that that region mostly catered historically to European LPs and European LPs have just sought greater liquidity, and that's been achieved through UCITS structures.

Paul: Sure.

Michael: So, I think that there's just not as deep of a pond to fish in over there on the equity side. And then what else does that leave in Europe? It's, right—obviously there's a credit market. It's smaller than it is here. Um, but comes with certain inefficiencies, especially because on a regional basis, right, like, sourcing of paper could be done at a very localized level.
But I, I, I, I mean, I think, you know, principally the way that I see European exposure sort of manifesting itself through portfolios is, is more from the macro side today in terms of people trading either sterling or, or, or rates. And, I mean, that is, that is not—those are not structural allocations, and Brexit has played a large component of that and what the ECB's, you know, monetary policy is.
But Europe is, is frankly just in summarizing, I think it's just a smaller pond to fish in from a management perspective.

Paul: Yeah, we would agree. I mean, on a traditional hedge fund side, we would definitely agree. I mean, where we're—so we're not doing, you know, we're not really bringing on any new allocations on a traditional hedge fund side in our focus on Europe. Happy with kind of what we have. I'd say it is different on a private credit side. So, you know, obviously there continues to be a lot of pressure on, um, you know, on weaker banks in, in Europe to, uh, you know—there's increased capital charge. There's increased regulatory pressure to, uh, to push out non-performing loans. And obviously there's, uh, a tremendous amount of new and existing managers that are, you know, private credit in between hedge funds and private equity to kind of capitalize on that. So, we've built up a lot of allocations, uh, in both kind of dedicated pockets as, as well as kind of hybrid, um, client portfolios that have capitalized on that. So, you know, non-performing loan focus or reg cap focused or other lending oriented strategies.

Kenny: In our, in our most recent survey, we asked a question, uh, for the second time on ESG, so environmental, social and governance. What's interesting, though, is the term "impact" has come up. Paul and Michael, what is your view on ESG.

Paul: I'd say the quality of the products, uh, on the hedge fund side is a little spotty, uh, which is why, you know, again, there are some good ones, but it's, it's, it's not a, you know, it's not a tremendously deep,

But, look, the, the challenge of the ESG space is that a lot of people want a lot of different things. It's hard to meet the marketplace demand, and, and thinking about how does is that best implemented on the hedge fund side, right? Like, for just on an exclusionary stock basis is, is generally considered kind of not enough and, you know, something of kind of yesteryear. On the other hand, if you kind of go to the other extreme and, and focus much more on impact, I think investors' reaction is going to be I, I want alpha first and foremost. So, you kind of have to have something in between, and that's kind of where we landed, which is let's focus on alpha first and foremost but let's focus on managers, um, that oftentimes are thinking about ESG from the standpoint of, of capitalizing on the structural growth and change that ESG is creating, and trying to identify companies that are increasingly becoming more ESG focused and are going to benefit and perhaps get higher, you know, higher valuations and multiple because of that.

Michael: Yeah, what I would say, um, to address your question, Kenny, on that front is I think part of it is why is—yes, why hedge funds have lagged the rest of the marketplace in ESG adoption. I think part of it is the fact that they run unconstrained strategies by their very nature that tend to be concentrated in, in what they do. So, this concept of looking for best ideas is purely focused on, right, like, where can I achieve the greatest risk-reward nature of things? So, um, you know, I think it is going to be hard. I think you do have to—it is, it is different for everybody, and I think what you're doing is, is the right thing. We've, you know, just within wealth management it's been much easier to tackle from a traditional perspective. And so, we've been really focused on it. We hired someone to lead our sustainable investing efforts, and what we're focused on is, uh, delivering multi asset class solutions, um, in an ESG framework.

Kenny: Yeah. Paul and Michael, I want to ask you about new launches. So, in, in our survey, 43 percent of investors recently mentioned they allocated to a new launch in 2018. We've seen a growing interest in new launches. Paul, how does the asset management think about new launches?

Paul: Sure. Um, so historically we've always been extremely dedicated to the space, so, you know, 65 percent of managers with whom we've invested on Day 1 have been emergent. So, I mean, the first question is, like, what are you exactly looking for with emerging managers? And, like, for us oftentimes what we're looking for is access to a manager and a strategy that doesn't exist at a larger size, so it's not scalable. So, you know, on, on the quant machine learning side, you know, maybe it's a manager that can only—only has capacity of $500 million and it pays to get in early. Um, because, you know, over and above that, they're going to change what they're doing in terms of the time horizon's going to go out and it's not going to become interesting, so you have to get in early. There's value in getting in early. Um, or, you know, the fees and kind of the deal that you're getting is sufficiently attractive that you're compelled to kind of invest in it at an early stage. But more broadly, I'd say our efforts have been focused mostly on the quant space, and strangely in long-short equities, we're actually finding—because you have to say, like, where does the inefficiency exist? Oftentimes in emerging, we would actually say there's an inefficiency that exists for managers that have been around a while that have been forgotten about in, in a marketplace.

Kenny: That's interesting.

Paul: we found $2, $3 billion managers that we don't normally invest with in Years 3 or 4, but, you know, that are still offering attractive terms that we felt, everything else equal, was a much better, um, opportunity than necessarily getting excited about, you know, the new manager that's launching in long-short.

Kenny: That's great. Michael, as you sort of think about, uh, the year ahead, how are you thinking about the managers in your platform? Are you thinking, expecting, lower turnover or higher turnover? Neutral?

Paul: Hopefully not too high, right?

Michael: Yeah. Definitely don't want it to be like in years past. I, I, I think, um, just like if you were to ask any hedge fund manager, "How do you feel about your book today?" right, they, they love their book.

Paul: Talk to me at the end of the year.

Michael: Look, I, I would say I think it's important for us to reflect on this. We were disappointed in last year, but the setup was really good. Rising rate environment. We think that, that QE had naturally suppressed, um, the alpha proposition for a host of different reasons. And, you know, you asked about targets beforehand. I think one of the other things that hedge funds have to do is they have to provide natural diversification to a portfolio. And sometimes we're so in our hedge fund world that we talk about beta and alpha and this and that. I think part of it is as simple as what's the return relatively to a 60/40 portfolio, right?

Kenny: That's a great point.

Michael: Um, we don't only manage portfolios of hedge funds, so we have a, a bit of a wider toolkit, and one of the things that we're doing is how do we use hedge fund structures or vehicles to create, um, a, a risk profile and something that has a more attractive fee associated with it. So, an example might be, um, high-yield munis, right? We have a big US taxable client base, um, and that market is one where you need specialization, and so we could create a structure around that. And that, that's a little bit unique, but we're thinking about how do we complement what we do on the traditional hedge fund side by using the vehicle to offer what we believe are attractive solutions to our clients.

Paul: Yeah, I mean, you need to innovate, right? And, and we're doing, you know, we're doing the same thing. So, kind of working with managers to structure solutions that work better for us. Part of it is getting fee savings, but part of it is maybe carving out a small piece of what they're doing and, you know, making that a, a, you know, making that a much broader opportunity. Uh, co-investments would be another one. Um, and it brings down fees, higher, uh, return potential. So, it's evolving.

Kenny: That's great. Last question. If you had a crystal ball, what do you think's a surprise we can expect in the industry in the next 12 to 24 months?

Paul: Well, if we had a crystal ball, it wouldn't be a surprise.

Paul: Yeah. Yeah, yeah, yeah. Well, yeah, I mean, look, on ESG, going back to ESG, I, I, I think the impact of ESG in terms of how, you know, the growth of ESG on a worldwide basis, on what it's going to mean for the hedge fund industry, is certainly being underestimated. And similarly, you know, on, on the, uh, on the quantitative side, machine learning side, you know, like, when you're sitting down and, and talking to these managers and really kind of getting into the weeds of what machine learning is, natural language processing, and understanding obviously the impact not only in the wider world but the impact, you know, on the investment management industry, like, and, and, and obviously the growth in data and everything associated with it, like, people get it. It's not a, you know, it's not a surprise in, in one hand.
But I still think it's vastly underestimated. I mean, it's just, it's just such shocking the, the, the impact and the power of it. And, yeah, I, I still just think it's, it's dramatically underestimated and if people are not paying attention, they're going to get run over.

Michael: I think you started this by saying that 70 percent of, uh, the, the survey, uh, respondents were frustrated with performance. I think the surprise is going to be the inverse of that.

Kenny: Yeah. That's great.

Michael: That, that performance is going to, uh, outperform expectations. And so, I look forward to the conversation that we have on the back of that.

Kenny: There you go.

Paul: Yeah.

Kenny: It's great to end on a positive note. Well, that's it for today's podcast. Paul, Mike, uh, thank you for both providing valuable insights, and thank you to our listeners for tuning in. Any questions in the meantime, feel free to reach out to a J.P. Morgan representative. Thanks, guys

Michael: Thanks very much, Kenny.

Paul: Thank you. Yeah, appreciate it.

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