Alternatives necessary to truly diversify and protect against inflation

  • Describe the challenges from inflation on portfolio construction
  • Explain what alternative assets are
  • Describe risk parity
Alternatives necessary to truly diversify and protect against inflation

Even as we move past peak inflation, in our view it is likely to settle at a higher level than before the inflation shock. 

This means that the traditional 60 per cent equities/40 per cent bonds balanced portfolio will continue to struggle. In a regime of rising inflation and rising interest rates, nominal bonds struggle to keep pace with inflation and lose value in real terms. 

It is only once we move to falling inflation and falling interest rates that bonds have potential for capital appreciation.

Article continues after advert

As equities provide a long-term inflation hedge, it means the '60' is not a problem, but the '40' remains vulnerable to persistent inflation. Advisers need to consider what they can do to boost resilience in the defensive side of a portfolio, without materially increasing risk budget.

There are two ways of building up additional inflation resilience and diversification in our view.  One is asset-based diversification, and the other is risk-based diversification.

Asset-based diversification

Diversification is the original concept behind the 60/40 portfolio. But if bonds are increasingly correlated with equities, we need different sources of diversification. 

By allocating across different uncorrelated asset categories, advisers can attempt to moderate portfolio volatility by taking advantage of the de-correlation effect. This is when the volatility of the whole is less than the sum of its parts.  

In our asset exposure framework, alternative asset exposures include liquid real assets, listed private market managers, and alternatives and private markets. We look at each of these in turn.

Liquid real assets

Gold and precious metals, commodities, natural resources, listed property, and listed infrastructure; these are 'real asset' because they are 'things' that should preserve their value in inflationary time. They are 'liquid' because they can be accessed in a format that is readily tradable. We look at the main components in more detail:

Gold and precious metals can be accessed using exchange-traded commodities (ETCs), or in the funds world by accessing gold producers equities as a proxy. Gold is a traditional real-asset inflation-hedge; it preserves its value (purchasing power) over time and is a classic risk-off asset that can help protect a portfolio in times of market stress. 

Some critics of holding physical gold argue that it produces no income and therefore has no intrinsic value or growth potential, yet it can hold its value in inflationary and even in hyper-inflationary times. Gold can also act as a shock absorber in times of market stress. Gold can be incorporated into a portfolio on a standalone basis or as part of a real assets strategy. 

Other precious metals such as silver, platinum and palladium combine both store-of-value characteristics with specialist industrial applications.

Commodities such as energy (crude oil, natural gas, heating oil, petrol and diesel), agriculture (soybeans, corn, coffee, sugar, livestock), industrial metals (copper, nickel, aluminium, zinc and lead) can be best accessed using ETCs.