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The new rules of diversification investors should follow

15 November 2022

Strategic allocation among various alternative assets can potentially protect investors from higher inflation and tightening correlations.

By Anthony Tutrone,

Neuberger Berman

Not long ago, a reasonably balanced investment portfolio might have included a mix of 60% public stocks and 40% bonds. But that familiar 60/40 strategy may no longer be up to the task, thanks to the arrival of stubborn inflation, tighter assets correlations, and more modest estimated future returns.

As an inflation hedge, both private equity (PE) and private credit (PC) can offer welcome protection. The key, as ever, is in the underwriting. For example, one would want to invest in companies that have pricing power and have labour costs that tend to move in tandem with revenues.

Real assets with predictable cash flows and embedded price escalators (think real estate and infrastructure) can help hedge rising prices – as can certain commodities, such as precious metals (crucial to low-carbon technologies) and basic proteins (to smooth disrupted food supply chains). On the credit side, private loans are often issued at floating rates, which helps offset inflation.

Alternatives can also provide diversification while generating compelling risk-adjusted returns. With more companies choosing to remain privately held for longer, potential PE targets significantly outnumber public stocks. That larger universe contains many small, faster-growing businesses to which investors may not have access through public markets.

Another benefit of private investments, in our view, is having operational control over portfolio companies. As deals have become more heavily equitized, creating value through financial engineering has gotten harder. In this new era, we believe focusing on “operational alpha” through strategic expertise and disciplined management may prove a better approach.

Focusing on higher-quality assets helps, too, especially during downturns. For example, of the 40 to 50 co-investments we underwrote in 2021, all had projected organic growth of over 5% over the next five years – and more than half over 10%.

To be clear, we do not believe in timing this market, but rather that seasoned investors should apply a consistent approach, with the understanding that certain PE fund vintages will perform better than others. Based on historical patterns, the best-performing funds tend to launch after public-market downturns (when valuations are lower), while the poorest often start the clock two or three years before a public peak.

For all their potential, alternative assets are also more illiquid than publicly traded stocks and bonds, and we believe investors should strongly consider their liquidity needs while seeking to diversify their portfolios in this challenging environment.

Anthony Tutrone is global head of alternatives at Neuberger Berman. The views expressed above should not be taken as investment advice.

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