Endowments and foundations have benefited from double-digit returns in recent years as a result of strong U.S. public equity markets and a shift to alternatives, like private equity. As interest rates increase and global growth remains muted, however, these organizations will need to adapt their investment approach. In a market environment that is likely to be characterized by lower absolute beta returns, not-for-profit organizations are reassessing their beta-to-alpha mix. In the lower-return public equity environment, they are starting to shift from beta-oriented strategies to more intelligently sourced alpha in both public and private markets. They are also actively restructuring their risk management toward more return-oriented strategies.
From a macroeconomic perspective, global economic and financial cycles have moved beyond the recovery phase into a normalization phase in which asset values are fairly priced. In the bond market, normalization is represented by a tug-of-war between the economy and the impact of public policy quantitative easing around the world, particularly in Japan and Europe. In public equity markets, dispersion and volatility levels have been rising, a situation that, in turn, is creating a stronger case for active management. The risk profile of passive investments will be set by the market, whereas active managers can proactively manage risk. In particular, in emerging markets, active managers with a local presence have strategic research advantages in looking across the breadth of equity opportunities to find growth potential within specific regions. In U.S. markets, as endowments and foundations are readily reevaluating their manager selection, active equity managers must delineate across a much smaller opportunity set along sectors to deliver target returns. Diversifying across styles or market caps can thus help add alpha or mitigate volatility in equity allocations.
Faced with a more challenging return environment going forward, nonprofit organizations are also looking to generate alpha by investing in less liquid long-term opportunities. In 2014 private equity was one of the strongest drivers of endowment returns. We believe that over the long term, private equity continues to offer significant opportunity for return enhancement for endowments and foundations when compared with public assets. Strategic corporate buyers are willing to pay higher prices in private equity transactions to augment existing operations or platforms in their businesses, in the hope of ultimately generating greater brand value. Meanwhile, a high degree of purchasing power in the form of dry powder remains not just on corporate balance sheets but also with financial sponsors.
Real assets are providing another attractive opportunity. Value-added real estate remains a bright spot as the commercial supply remains far below demand and the nonresidential supply has recently started to pick up. Employment growth is the primary driver for commercial real estate demand. In particular, demand is improving across population segments that are prime users of high-grade office space. Infrastructure investing represents another unique opportunity, given the fact that many countries, particularly in Europe, need to build or upgrade their physical systems.
The story in fixed income is familiar. Sovereign bond yields are likely to be negative in the short term. In our view at J.P. Morgan Asset Management, it will take three years for fixed-income yields to normalize fully in the U.S. and potentially four to five years in Europe. Despite this timeline, there are some potential investment opportunities among benchmark agnostic and absolute-return managers.
Opportunities in private credit are selectively available, as regulatory changes have forced many traditional lenders, particularly banks, to pull back on their higher-risk lending businesses. Because loans to middle-market companies are a fraction of what they were in 2005, there are opportunities for private investors to fill this funding gap on attractive terms. There are opportunities in private junior debt, where we expect to see returns in the low- to mid-double digits over the next several years.
In a market environment that is likely to be characterized by lower absolute beta returns, investment opportunities that can provide diversification, flexibility and premiums above publicly traded options are likely to represent attractive options for not-for-profit organizations.
Monica Issar is global head of endowments and foundations at J.P. Morgan Asset Management in New York.
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