Investors Seek Diversification Amid Inflation
Investors are increasingly concerned about growth shocks, inflation, and market concentration. While the timing and impact of these risks remain uncertain, diversification is seen as a key strategy to mitigate them.
Jared Gross, Managing Director at J.P. Morgan Asset Management, highlights the evolving nature of these risks. He emphasizes the need to control inflation and concentration risks in portfolios, suggesting that alternatives can play a key role in diversification.
Inflation and the Role of Alternatives
Inflation remains a core risk for investors, as evidenced by recent bond market volatility. While inflation is less surprising now than in 2022, its impact is still significant.
Gross notes that inflation-linked bonds and cash instruments with floating rates can act as direct hedges. However, their low returns make it challenging for investors to hold enough of these assets to effectively manage inflation risk over the long term.
Instead, many investors focus on outperforming inflation through equity allocations. The assumption is that corporate earnings will grow with GDP and exceed inflation. However, concentration risk in equity markets, particularly in AI-related stocks, complicates this strategy.
Gross suggests that certain real assets like real estate, infrastructure, transportation, and commodities can offer long-term returns while demonstrating resilience to inflation.
Addressing AI Concentration Risk
The US equity market is heavily concentrated in AI-related stocks, with nine of the top ten S&P 500 companies tied to this theme.
While this concentration is partly justified by earnings, it still poses risks. Gross points out that these large companies could face disruption, and the passive investing momentum driving their performance might reverse.
AI concentration extends beyond equities, with investment-grade credit indices heavily weighted towards AI due to the debt issued by AI hyperscalers. The AI data center buildout relies on land, energy, and construction, making it an infrastructure play as much as a technology theme.
Diversifying from AI involves both hedging against concentration and diversifying AI exposure. Gross suggests that actively managed value and quality strategies could offer advantages if AI momentum reverses.
In the alternatives space, he identifies assets with varying degrees of AI exposure. Closed-end infrastructure funds, for example, often have significant exposure to AI data center construction due to the infrastructure-like nature of modern data centers.
Regulated power delivery is another area with AI connections. Utilities with excess power capacity can charge premiums to data centers and reinvest in further generation.
For investors seeking to minimize AI exposure, Gross recommends core real estate and government bonds.
When considering alternatives, Gross stresses the importance of manager selection and vetting. He notes that in alternatives, manager skill is a more significant driver of outcomes than in public markets, where market beta dominates.
Gross concludes that strategies with lower risk profiles and minimal AI exposure can provide a hedge or safe haven without necessarily sacrificing returns.
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