“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.