Diversifying against the big risks JP Morgan sees today

Each month at WP we focus on a particular topic of interest to advisors. This October we’re focusing on private assets and alternatives.

Investors are aware of the big risks that could be facing their portfolios, on the broadest level. They know that a growth shock can come, that inflation can rear its head, or that markets can become too concentrated and correct. What they don’t know is when those risks will come and the magnitude of their impact on portfolios. That’s why investors follow Harry Markowitz to “the only free lunch in investing”: diversification. In the low inflation decades that preceded the 2020s, the 60/40 formula of equities and bonds appeared like it was enough diversification to work. Today, however, new risks are apparent even if their timing and magnitude remain unclear. Those risks should prompt investors and advisors to question how they will diversify.

Jared Gross, Managing Director and Head of Institutional Portfolio Strategy at J.P. Morgan Asset Management outlined the state of growth, inflation, and concentration risk as he sees them. While growth risks are present, he stressed the increasing importance of controlling for inflation and concentration risks in portfolios today. He emphasized how the dynamics between those sets of risk has changed and outlined how alternatives as a broad asset class can help diversify against those risks.

“When you think about risks that you want to diversify, there is a classic adage in the markets that you diversify the risks you do not know, you hedge the risks you do know,” Gross says. “And I think what that really means to most investors in practice is we understand that there are certain risks that show up at some point in time. We don’t know when. We don’t know to what magnitude. But they have the potential to cause significant damage to the value of a portfolio.”

Managing inflation risk with alternatives

Inflation remains a core risk for investors today, as recent bond volatility demonstrates. However, Gross notes that the surprise of a risk like inflation serves to amplify its magnitude. Unlike 2022, inflation is not as surprising as it once was, making the risk somewhat more muted.

Nevertheless, for investors seeking to manage inflation risk, Gross explains that there have been some historic asset classes designed to protect against inflation. Namely inflation-linked bonds and cash instruments which can operate in a floating rate structure. However, he says that it’s difficult for investors to hold enough of these instruments to form an effective hedge over the long-term, as their typically low return profile means the investor ends up underperforming return targets.

While direct inflation hedges have the drawback of dampening long-term returns, Gross says that many investors have simply acknowledged that out-earning inflation in the long-term is the best way to manage that risk. That has traditionally meant an equity allocation, with the view that corporate earnings will be tied to GDP growth and therefore exceed inflation. However, the issue of concentration risk poses some challenges to a pure equity inflation hedge today.

Gross says that certain real assets should be viewed favourably in this light. Real estate, infrastructure, transportation, and even some commodities like timber can produce long-term returns that meet client expectations, while showing significant resilience in the face of inflation.

Diverisifying AI concentration risk

The other risk being identified in headlines and op-eds is the growing market concentration in a single investable theme: artificial intelligence. US equity markets have become highly concentrated in AI-related stocks, with nine of the top ten names on the S&P 500 connected directly to the theme. Those mega-cap AI and tech stocks now represent roughly 40 per cent of the benchmark, which might give some investors pause. Gross caveats that point by noting that the big tech names on the S&P 500 represent roughly 40 per cent of corporate earnings as well, making their concentration somewhat more ‘earned’ than the case of the revenue negative names that typified the dot com bubble. Nevertheless, there is a risk that those large companies may face disruption and that the passive investing momentum that has played a role in their performance might reverse.

AI concentration also now extends beyond equities. Many of the AI ‘hyperscalers’ have issued a significant amount of debt, causing investment grade credit indices to carry a hefty weighting to AI. Because the AI data center buildout narrative is as much about land, energy, and construction it has become as much an infrastructure play as a technology theme.

Diversifying from this theme involves both hedging against AI concentration entirely and diversifying the kinds of AI exposure that a portfolio carries. If momentum in AI reverses, Gross believes that actively managed value and quality strategies might offer some advantages. Looking at the alternatives space, he identified areas that now carry some connection to AI and sectors that are more insulated from the theme, arguing that investors may want to consider a combination of differentiated AI exposure and wholly non-exposed assets.

Closed-end infrastructure funds, Gross says, can carry a high degree of exposure to AI data center construction. That’s because modern data centers function as infrastructure more than pure real estate, with a high degree of maintenance required and expensive internal components typically being built on cheap and widely available land near power generation.

Regulated power delivery also offers an interesting way to play the AI theme, Gross notes, with some of those utilities with excess power in a strong position to charge a premium to data centers and reinvest that additional revenue in further generation.

For investors who want to remove AI exposure from parts of their portfolio, Gross suggests that core real estate offers less than one per cent exposure to data centers. Government bonds, as well, have recently demonstrated negative correlation against US equities, making them a useful diversifier.

For advisors who want to find differentiated ways to manage both inflation and concentration risk, and are considering alternatives, Gross emphasizes the importance of manager selection and vetting in their process.

“The basic rule with alternatives is manager selection and individual fund performance is a much greater driver of outcomes than public market strategies where the market beta is the dominant factor that drives outcomes. And that’s both a risk, but it also means that a well-chosen strategy in any category can navigate this market environment successfully,” Gross says. “I do think strategies that are lower in the risk spectrum and/or have very low AI content are a useful hedge or place of greater safety in the event something goes wrong. And those don’t have to be low-returning investments.”