Can You Reduce Systematic Risk in Your Client’s Portfolio?

Index funds have become a dominant feature of investment portfolios. This year, investments in index, or “passive” funds surpassed active investment strategies for the first time in history (Morningstar, 2024). Moreover, individuals in the U.S. are now more invested in the markets than ever before, according to 2023 data from the Federal Reserve. While these investing shifts have brought numerous benefits, there may also be unintended consequences, including vulnerability to the effect of unethical business practices on retirement portfolios. Systems-level asset management is one way to safeguard portfolios against systematic risk.

Index Investing Takes Center Stage

An index fund is one that tracks the performance of a financial index, such as the S&P 500, by investing in all the stocks or bonds of that index. These funds were initially created in the ‘70s to make it easier for investors to diversify their portfolios, thereby reducing their risk exposure. Over half a century later, ease of access has led to a preference for index  strategies, surpassing fifty percent of the market share of all funds in 2024. Moreover, the trend is buoyed by widespread retail investing in financial markets, including through indirect investments in 401(k) retirement accounts (WSJ Article, December 2023).

While an active management strategy attempts to beat the total market returns through trading securities to outperform benchmarks, the goal of an index strategy (sometimes called passive investing) is to match the return of “the market,” as defined by the selected index (e.g., FTSE, S&P, Dow, etc.).

The benefits of index funds include expanded access to capital markets for those who may not have the expertise, or time, to manage an actively traded portfolio. Additionally, index investing not only allows ease of access to portfolio diversification, but also appeals to those who believe an investor can’t reliably “beat the market” through single stock ownership. And finally, index funds can be more cost-effective than actively managed funds because managers tend to charge lower fees when tracking an index, thus putting more money back into investors’ pockets.

Systematic Risks Remain, Despite Widespread Diversification

Despite the widespread popularity of diversification through index funds, investors remain vulnerable to systematic risk. When investors diversify through index strategies, they seek protection against volatility in their portfolio because of idiosyncratic risks that arise when putting all your eggs in one basket. For instance, if an investor is overweighted in healthcare stocks, the financial loss resulting from policy change that impacts healthcare would be greater. By diversifying, investors put their eggs in multiple baskets for protection against these specific risks unique to individual sectors or stocks.

Even with diversification, however, portfolios remain vulnerable to systematic risks, such as inflation, war, recessions, and other geopolitical or macroeconomic trends. These are risks that impact the entire market. While diversification protects against idiosyncratic risks, its widespread adoption by investors hasn’t improved exposure to systematic threats. As investors have embraced diversification, what determines their portfolios’ long-term value will be the economy’s intrinsic value, not the relative value of each company in the portfolio. (The Shareholder Commons, 2022). Furthermore, because more individuals are invested in financial markets today than at any time in history, systematic threats could lead to broader financial challenges.

Yet, as Jon Lukomnik and James Hawley argue (2019), the structure of the asset management industry—including the proliferation of undifferentiated products and complex fee structures—combined with the pervasiveness of index investing, has led to portfolios that overlook systematic risks. This makes investors vulnerable to long-term economic threats such as geopolitical issues and climate change (Lukomnik & Hawley, 2019). This threat is particularly pernicious when planning for retirement, which is necessarily long-term. 

A Systems Lens on Investing Can Address Unethical Business Practices

In recent years, there has been an increasing negative impact of commercial activity on society, also known as externalities. There are numerous statistics to demonstrate this point; one stark example is that by 2050, the continued expansion of global commercial activity is likely to deplete access to critical freshwater resources by one half of the Earth’s total capacity (Albert, et. al., 2021).

Systems investors analyze financial markets by taking into consideration the effect of corporate externalities on the financial, social, and environmental systems on which our capital markets rely. Neglecting externalities can exacerbate risks to these systems. Viewed through a systems lens, this type of market analysis recognizes that the externalities of one business impact the potential success of the entire market through negative feedback loops, thus affecting an entire portfolio. A diversified investor recognizes that externalities produced by one company creates costs borne by other companies in their portfolio. Diversified index investors often own the entire market, and therefore will be financially impacted by these externalities.

We have seen these consequences in the global financial crisis of 2008 to 2009, ultimately resulting in overall financial market instability. As these risks created by companies externalizing costs materialize, asset values may sharply decline, leading to broader market disruptions and increased financial volatility.

This may sound like environmental, social, and governance (ESG) investing or responsible investing, but it’s different. While ESG investors create portfolios that integrate environmental and social considerations with financial returns, systems-level investors seek paradigm shifts on issues that can bring about widespread change to benefit the entire market. (Flamer, 2024). On one hand, a responsible investor might, for instance, exclude companies from a portfolio because of personal values (e.g., gun manufacturers) or select ESG funds that generate social and environmental rewards (e.g., green energy). System-level investing, on the other hand, attempts to affect overall market returns through opportunities to influence enterprise risk and return, with an eye towards the long-term resilience of capital markets (Burckart & Lyndenberg, 2021).

The example above about depleting freshwater resources can demonstrate this distinction. Traditional financial analysis deems environment-related costs like clean-up initiatives as expenses to be minimized. For instance, a shareholder in any one beverage company has an incentive for that company to spend just enough on clean water initiatives to ensure that company’s access to clean water, even if those expenditures create externalities that negatively impact others (e.g., by dumping toxins into a different water basin).

A systems-level approach identifies industries in which water use is most intensive (e.g., chemical manufacturing, agriculture, beverages), conducts a portfolio-level analysis of their water footprint to analyze the relevant feedback loops. Then, the analysis identifies the weakest performers within them for engagement. Because such an investor has portfolio exposure to numerous companies that need fresh water, they will support water management practices that do not deplete access to water for other businesses.

In this way, the feedback loops of the ecological systems are integrated into financial market analysis.

Strategies for Investors

Putting these considerations into practice requires strategic effort by asset managers and owners. The dearth of analysis about systematic phenomena could be a blind spot in long-term investing.

To improve the resiliency of the financial markets, asset managers need skills in both searching for new investment opportunities and stewarding existing assets in index funds, contends economist John Kay (2015). His critique of the industry is that “chasing alpha” through fee-generating buy/sell trades to try to anticipate market expectations is shortsighted because it overlooks opportunities to meaningfully assess drivers of asset value (Kay, 2015). Trading might benefit enterprise-level risk/return, but doesn’t address market-level systematic risks. Investment stewardship activities can be used to shift the perspective of corporate managers toward the portfolio-level interests of diversified shareholders.

One prominent approach is beta stewardship, which is investment stewardship that prioritizes reduction of corporate externalities. While stewardship through ESG integration seeks opportunities for a double bottom line (do well financially by doing good for the planet), beta stewardship recognizes that such an approach is not enough, because systematic risks affect the overall market, not just one company. Thus, even if some companies in a portfolio benefit from issuing green bonds or buying carbon offsets for sustainability projects, discrete efforts will not be enough to solve the impending environmental challenges that all businesses confront.

Beta stewardship involves analysis of the feedback loops in economic systems, and advocates that companies manage business consistent with systems-level effects. A recognized example of beta stewardship is Climate Action 100+, an investor-led initiative targeting the world’s largest corporate greenhouse gas emitters to take steps to avoid externalities that affect economic growth, food production, infrastructure, and water supplies.

Another organization that provides systems-level analysis is The Shareholder Commons. Among their proposed beta stewardship practices is the concept of guardrails, which are measurable and universalizable parameters for corporate activities that cause externalities borne by the overall market. One example of a guardrail is reducing corporate overuse and misuse of antibiotics/antimicrobials in animal agriculture and human health care and hygiene products (The Shareholder Commons, 2022). Antimicrobial resistance is a threat to human health; this occurs when microbes transform over time, no longer responding to disease treatment through antibiotics. Current health care and business practices accelerate this trend. Each single company has an incentive to continue antibiotic and antimicrobial use at current levels because it can enhance production processes, even if they contribute to long-term resistance among the entire population. Developing a standard approach and commitment across companies through guardrails aims to move the needle on an intractable systems-level challenge.

Planning for the Future

Some may think strategic efforts toward systems analysis should be limited to pension funds that manage large, defined benefit programs. But the well-documented shift towards defined contribution plans, such as 401(k) retirement plans, means individual retirees are more invested in the market today than any time in history (Blackrock, 2024). I believe a systems-level lens on managing assets is needed to benefit all investors.

All investors have a role to play in planning for the future:

• Asset managers should prioritize systems-level approaches by examining case studies that describe a business case for systems change and integrating these approaches into their stewardship practices.
• Financial advisors should probe managers on their approach to protecting against systematic risk, and how systems investing factors into their analysis.
• Individual investors should select managers and financial professionals that think critically about long-term performance, and the effects of systematic market risks on retirement plans.

We can achieve these objectives by identifying organizations that have published their stewardship codes and engagement practices, as well as those that promote transparency relating to corporate governance priorities.

Additionally, the financial industry should invest in high-quality research that can further demonstrate how ethical business practices contribute to financial resilience. Now that’s a basket we would all be willing to put our eggs in for the long-term. 

Footnotes

Burckhart, W. & Lydenberg, S. (2021), 21st Century Investing: Redirecting financial stragies to drive systems change.  Berrett-Koehler Publishers

Lukomnik, J. & Hawley, J. P. (2021), Moving Beyond Modern Portfolio Theory. Routledge.

Lukomnik, J. & Hawley, J.P. (2019), The Purpose of Asset Management, Pension Insurance Corporation.

https://www.pensioncorporation.com/content/dam/pic/corporate/documents/news-and-insight/insight/2017/the-purpose-of-asset-management-v4.1.pdf.downloadasset.pdf

Kay, J.A. (2015). Other People’s Money: the real business of finance. Profile Books.

Albert et. al. (2021). Scientists' warning to humanity on the freshwater biodiversity crisis. Ambio, a journal of environment and society, 50(1): 85 - 94. https://www.ncbi.nlm.nih.gov/pmc/articles/PMC7708569/

Flamer, C. (March 14, 2024). ESG vs. Systems-Level Investing. The Institute for Corporate Governance, Kelley School of Business. Retrieved October 28, 2024. https://icgblog.kelley.iu.edu/2024/03/14/esg-vs-system-level-investing-featuring-caroline-flammer/

South Pole Carbon Asset Management Ltd.(2020, June 16). An Investor Guide on Basin Water Security Engagement: Aligning with SDG 6. https://assets.ceres.org/sites/default/files/An%20Investor%20Guide%20on%20Basin%20Water%20Security%20Engagement_%20Aligning%20with%20SDG%206.pdf

The Shareholder Commons (2022, September). Antimicrobial resistance and the Engagement Gap: Why investors must do more than move the needle, and how they can. https://theshareholdercommons.com/wp-content/uploads/2022/09/AMR-Case-Study-FINAL.pdf

The Shareholder Commons (2024). Stewardship Practices. Retrieved October 28, 2024. https://theshareholdercommons.com/system-stewardship/#stewardship-practices

Hannah M. (December 18, 2023). More Americans Than Ever Own Stocks. Wall Street Journal. https://www.wsj.com/finance/stocks/stocks-americans-own-most-ever-9f6fd963

Blackrock, Inc. (2024). Larry  Fink’s 2024 Annual Letter to Investors: Time to rethink retirement. https://www.blackrock.com/corporate/investor-relations/larry-fink-annual-chairmans-letter 

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