• AIQ - The Macro Stewardship Edition
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Moving mountains and markets

A new way to approach systematic risk

A series of market failures have brutally exposed the shortcomings of Modern Portfolio Theory. However, market participants play an active role in markets; they are not mere bystanders. Understanding this could provide a better way to think about and deal with systematic risk.

Read this article to understand:

  • The flaws in modern finance and risk management
  • How market participants can influence the overall market
  • New approaches to thinking about systematic and market risk
  • The practical effects of macro stewardship on investing and markets

There are few statements that represent the separation of today’s paradigm of investing from that of the past than the (now) ubiquitous words: “you have to think about risk as well as return.”1

This deceptively simple, yet revolutionary, notion put forward by Harry Markowitz sparked an explosion in theoretical and practical innovation in the field of risk management, laid the foundations for Modern Portfolio Theory (MPT).

Yet when we consider modern finance in the context of the vast systemic challenges we face today, it is clear that theory has made a fatal error of omission.

The problem is this. At the heart of finance is an unquestioned acceptance the market “is what it is”; it cannot be influenced.

But, as one of the main MPT protagonists William (Bill) Sharpe points out, we all rely on a well-functioning market. Reflecting on the impact his work has had on the investment industry, Sharpe remarked there will “be higher expected return for higher risk, but […] not just any risk […] the risk for which there will be a reward if markets are functioning well.” Sharpe reminds us this is “risk that […] cannot be diversified away”.

The unquestioned belief that the integrity2 of the market itself is treated as exogenous to market participants, whether active or passive, has blindsided investment and finance to any real, substantive notion of sustainability.

It doesn’t have to be this way; we can break free from the past. What if some of the core assumptions in finance were re-designed? Oliver Morriss, macro stewardship analyst at Aviva Investors, and his colleagues believe “MPT, for all its flaws, can be reimagined”.

To really unpick matters, though, we must first understand how we got here.

Systematic versus systemic risk

Despite being commonly used to refer to the same thing, it is important to understand the differences between systemic and systematic risk. They are different frames of reference, which originate from different disciplines (regulatory/governance practitioners and financial theorists) that were not designed or intended to fit together.

Systemic risk refers to the risk of a breakdown of an entire system rather than simply the failure of individual parts. In a financial context, it denotes the risk of a cascading failure in the financial sector, caused by linkages within the financial system, resulting in a severe economic downturn.

Systematic risk is that which is deemed to be inherent in the overall system and affects the entire market or economy. It is non-diversifiable, and therefore the manifestation of systematic risk cannot be avoided. The drivers of systematic risk, however, can be dealt with.

The two concepts clearly intertwine and overlap – which is why confusion arises. In this article we do our best to use the terms in their proper context and to not use them interchangeably!

The only ‘free lunch’ in investing

Markowitz gave investors their only ‘free lunch’ – diversification. At the heart of his article Portfolio Selection, for which he received the Nobel Prize in Economic Sciences, is a simple rule: no risk, no reward.

In taking risk, Markowitz tells us, don’t put all your eggs in one basket – diversify! But he also brought new meaning to diversification, arguing it must be the “right” kind. That is, “it is necessary to avoid investing in securities with high covariances among themselves”.  

Yet, while diversification may be the best mechanism for reducing risk (framed in terms of ‘variance’), it has a propensity to dampen the opportunity to generate higher returns that might be obtained from more concentrated holdings.

Bill Sharpe, father of the Capital Asset Pricing Model (CAPM), built on this by starting from the basis all investors want to hold the most ‘efficient’ portfolio. In making a number of enabling assumptions, such as risk-free borrowing and lending, Sharpe concluded the optimal portfolio along Markowitz’s Efficient Frontier must be the market portfolio, a proxy for which would be the S&P 500 Index, which represents a broad basket of US stocks.3

From this, Sharpe could then calculate the price of each individual asset in capital markets. According to his CAPM, the only risk investors would be rewarded for bearing was that which could not be diversified away. Sharpe called this “systematic risk”, which has come to be represented by beta (β). Beta is a measure of an asset’s co-variance (or correlation) with the market. Sharpe distinguishes “systematic risk” from “unsystematic risk” – the portion of an asset’s risk that is uncorrelated with the market.

The problem? Once unsystematic, or idiosyncratic, risk has been diversified away, systematic (or market) risk accounts for as much as 91.5 per cent of the variability in investment returns.4

Gorging on the ‘free lunch’

One of the major failings of MPT, however, is a narrow conception of risk and the assumption all risks can be measured mathematically. In his 1921 work Risk, Uncertainty, and Profit, University of Chicago economist Frank Knight distinguished between risk and uncertainty. Whereas the former was quantifiable, the latter wasn’t.

We risk relegating the art of investing to the very rules of thumb and folklore these evolutions in theory proclaimed to take us away from

The disproportionate focus on volatility as a proxy for risk, and the subsequent overreliance upon diversification has the effect of placing what are systemic risks into the realm of uncertainty.

Jon Lukomnik, co-author of the 2021 book Moving Beyond Modern Portfolio Theory: Investing That Matters, holds a similar view. He wrote: “Prevailing investment orthodoxy just can’t simply deal with systemic risks, which has led investors to focus on the manifestation of risk as volatility but do nothing to tackle the underlying risk”.

In the never-ending quest to seek more sophisticated means by which we can manage risks, we risk relegating the art of investing to the very rules of thumb and folklore these evolutions in theory proclaimed to take us away from. The implicit assumption of exogeneity, and the notion a well-functioning market is a constant from which investors can make allocations to exploit inefficiencies, is starkly undermined by the threats we face today.

Risks – and returns

Once you challenge the idea markets are immovable objects, the next question becomes: “How might we rethink approaches to risk and return, or opportunity?”

The first point to make is ESG integration, the explicit and systematic inclusion of ESG issues in investment analysis and investment decisions,5 still fits into EMH as it simply represents consideration of information relevant to asset prices. Used properly, it can help investors achieve a more rounded view of diversification and risk.

From a downside perspective, the moral case for greater sustainability, fixing market failures and removing negative externalities is colliding with the financial one. The timelines of climate change and other major risks are collapsing in on us. No longer are they a problem of some distant tomorrow. They are affecting lives and portfolios, now.

This is why engagement with the underlying drivers and sources of risk, in a way investment orthodoxy does not envisage, is critical

This is why engagement with the underlying drivers and sources of risk, in a way investment orthodoxy does not envisage, is critical. Engagement with holdings, what we call micro-stewardship, is one important aspect of doing so; promoting sustainable practices and mitigating contribution to risks that may undermine the system within which they operate.

Macro stewardship – engagement with the system itself, via collaboration and consultation with peers, regulators, sovereigns and policymakers – is another mechanism for engaging with the underlying causes of risk. As Jess Foulds, global responsible investment senior manager at Aviva Investors, puts it: “What might active engagement look like if we thought about it through a systems lens, rather than merely at the local, individual issuer or corporate entity level?”

Aligning micro and macro stewardship efforts is crucial. “We can affect risk by changing the way capital is allocated, but we can also reduce overall market-level risk by engaging with governments,” says Foulds. Sovereign bondholders are yet to fully tap into their influence.

It is not just a risk mitigation story, though. As capital is increasingly directed towards transition themes, opportunities to generate returns are created as well.

“It will be increasingly important for those who are managing money to understand how policy will change,” notes Tom Tayler, senior manager in the Aviva Investors Sustainable Finance Centre of Excellence.

Moving towards a Sustainable Market Hypothesis

“The design of markets can be changed. They are human constructs. And, intuitively, market participants like professional investors are well placed to help advise on how to fix the cracks and weaknesses in the system,” argues Morriss.

In his mind, we need to re-imagine what it means to have an efficient market; that is, not just a market that is hard to beat, but also one that doesn’t jeopardise its functioning tomorrow because of how it operates today.

Policymakers and regulators, as the shapers of the investable universe, are critically important for ensuring the integrity of the market. But they cannot act alone and must be informed by financial market participants as part of a robust feedback loop. To that end, investors should look to collaborate with other institutions to complement their own bilateral engagement with governments and regulators.

Investor activity can and does have an impact upon the extent to which markets function

Morriss reckons attempts to mitigate risks of a non-diversifiable nature suggest we are moving towards a Sustainable Market Hypothesis (SMH). Investors are starting to acknowledge that rather than being exogenous to financial markets, they are indigenous to it. Therefore many of the risks to the financial system are endogenous; they originate from within.

“Investor activity can and does have an impact upon the extent to which markets function. If we can accept a well-functioning market is the lifeblood that generating a risk-adjusted return relies upon, it is high time we move to develop and embrace the SMH as a genuine theory for ensuring the market’s integrity,” says Morriss.

Although such an idea might seem far-fetched, just imagine what could be achieved if we set some of the brightest minds running towards the challenge of creating a more sustainable market structure. It is an ambitious thought, but maybe that metaphorical mountain of a market can be moved to a higher plane after all.


  1. Harry Markowitz, ‘Portfolio selection’, The Journal of Finance, Vol. 7, No. 1, pp. 77-91, March 1952
  2. In the UK, the FCA, which takes its authority from the Financial Services and Markets Act 2000, has, under its “enhancing market integrity” objective the goal of “protecting and enhancing the integrity of the financial system”, with “integrity” defined to include its soundness, stability and resilience, it is not being used for a purpose connected with financial crime, it is not being affected by market abuse (including insider dealing, unlawful disclosure of inside information, and market manipulation), the orderly operation of the financial markets, and the transparency of the price formation process in those markets
  3. William. F. Sharpe, ‘A simplified model for portfolio analysis’, Management Science, Vol. 9, No. 2, pp. 277-293, 1963
  4. Gary P. Brinson, et al., ‘Determinants of portfolio performance’, Financial Analysts Journal, Vol. 42, No. 4, pp. 39-44, 1986
  5. ‘Fixed income: What is ESG integration?’, UN Principles for Responsible Investment, April 25, 2018

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