It’s tempting to think of risk as a single thing: a number, a correlation, a shock, an event, a drawdown. But unless an investor has a single, simple objective, risk should be thought of as multifaceted.
Gene Podkaminer
Today’s investing environment is understandably complex, considering not only the unique macroeconomic configuration and market structure, but also the evolving asset allocation and portfolio construction tool kit. How should an investor make sense of risks? How should they prioritize? Is there a holistic, all-of-the-above approach?
Portfolio Recipe
A helpful analogy can be to think of portfolio risk as a layer cake. The most consequential risks are often determined high in the decision-making process, while others emerge from the implementation choices that follow. Understanding this hierarchy can help investors focus on the risks that matter most. At the top of the cake sits an investor’s objectives. Beneath are the major asset class trade-offs and allocation decisions. The bottom layer of the cake is implementation through managers: active, quant and passive; internal and external; public and private. The foundational layers determine the cake’s overall structure, while the layers above add nuance and refinement. Portfolio risk works much the same way.
The way investors define success directly informs how they classify risk. For instance, a pension fund’s objective is not simply to maximize return for a given level of risk, but to consistently fulfill obligations while accounting for the investable opportunity set, evolving demographics, liquidity needs, regulations and portfolio complexity. Put more simply, the definition of success does not just entail a high expected return, but the ability to pay obligations. In this context, risk cannot be thought of as merely standard deviation. It encompasses additional dimensions worth exploring.
For every asset pool, risk means vastly different things to various stakeholders. Where should they focus: tracking error, hedging or liquidity ratios, surplus risk, portfolio semi-variance, capital impairment, or downside capture? To the consternation and delight of risk teams everywhere, there is no one-size-fits-all measure.
Typically, the largest risks stem from the potentially uncompensated and often poorly specified mismatch between underlying investments and policy objectives. This is where long-term macroeconomic risks are expressed—for example, changing demographic profiles (fewer working age contributors, more retirees), technological boosts to productivity (artificial intelligence, potentially), inflation expectations and so on. A textbook example is defined benefit pension obligations and the assets that support them. Suppose these assets are structured, managed and measured in complete isolation from the evolving liability characteristics. The resulting friction or mismatch manifests as risk that can be larger than the cumulative security selection risk attributed to all an investor’s active managers combined. This is the highest and often most crucial level of risk awareness.
One of the pitfalls in asset allocation is diversification in name only: the appearance of diversification without meaningful diversification of the underlying risk factors. A beautifully constructed, multicolored pie chart with minuscule labels can provide a false sense of security. A more representative exposure profile may feature just a handful of macro factor exposures that cut across all investments—growth, inflation and rates. These macro factors impact every corner of the portfolio and drive correlations.
From there, deliberate trade-offs across big-picture asset classes inform how investors can array market and factor exposures. A guiding principle is that a significant amount of risk can result from significant decisions which may be overlooked—such as the split between U.S. and non-U.S. stocks—rather than those made routinely, such as choosing between two stocks within the same industry.
Lastly, it is critical to understand where and how your active and passive managers take risk. This is the lowest layer of the cake. Is the portfolio systematically or opportunistically carrying exposures in higher beta areas? Is the reward for mandate flexibility commensurate with your assessment of their selection and rotation skill? We’ve observed that many investors and investment committees are obsessively focused on this last level of risk, while placing far less emphasis on the bigger picture asset allocation and asset-to-goal alignment. Certainly, these risks are important but placing them properly in the hierarchy discussed above can be instructive.
Familiar Risks
Lately we’ve heard risk-related questions about market concentration and the Total Portfolio Approach, so let’s address both within our layer cake framework. As Capital Group Chief Investment Officer Martin Romo recently wrote, concentration risk is not new. In 1980, fossil fuels represented 29% of the S&P 500 Index, while Japan reached 44% of the MSCI World Index at the peak of its equity boom. Martin cautioned that while today’s areas of concentration may look different, history reminds us that these periods can create risks investors need to consider. Investors also should pay close attention to the “passive” label and understand the decisions embedded in benchmark construction, as well as whether the resulting exposures align with their objectives. Martin reminded us that active management can help investors exercise judgment around those risks while maintaining a focus on long-term outcomes.
We’ve seen this movie before and can consider these macro and index risks in at least two areas:
- Clarifying the many paths through which technological changes could cascade through the economy and thereby adjusting forecasts accordingly; and
- Acknowledging that indexes are not passive and that they actively embed decisions related to company inclusion, weighting systems and even country inclusion (observe the differences between index providers in classifying South Korea as an emerging or developed market economy).
Concentration issues have plagued markets for centuries. Will this time be different? What avenues are available to dampen potential risks from certain sectors or companies? Does active management play a role as a potential risk mitigator, alongside its role as a potential return driver?
TPA has been a hot topic of discussion among pension funds and sovereign wealth funds for years because it considers the many layers of risk holistically as part of a risk budget. Recently, many investors have become curious about AI exposure across all parts of their portfolios and have wondered whether early TPA adopters may have a clearer view.
We have written about its core tenets, including allocating decision rights where they can be most impactful; using a risk-factor framework to slice through asset classes and investments; viewing the portfolio as an integrated whole; and clearly articulating goals and the definition of success. Each of these elements has a significant risk dimension. While no two organizations implement TPA the same way, a focus on its core concepts can help frame the overall risk budget more clearly.
The overlapping nature of today’s investment environment calls for a more complete and coherent focus on portfolio risk—from macroeconomic forces to entrenched momentum in cap-weighted benchmarks. The key is not to treat every source of risk with the same level of attention, but instead to understand which risks have the greatest influence on the objectives and success of the portfolio. Risks flow through portfolios at multiple levels simultaneously. Tackling these at the highest level first can help prioritize objectives. In the end, successful investing is not about managing a single source of risk; it is about taking the right risks for the right reasons.
Gene Podkaminer is a senior asset allocation strategist at Capital Group. He has 25 years of investment industry experience and joined Capital Group in 2025. He has authored numerous articles published in the Journal of Portfolio Management and Journal of Investing focusing on risk factors in portfolio construction, asset allocation methodologies and the impact of macroeconomic shocks to multi-asset portfolios.
This feature is to provide general information only, does not constitute legal or tax advice, and cannot be used or substituted for legal or tax advice. Any opinions of the author do not necessarily reflect the stance of ISS STOXX or its affiliates.
Tags: correlation, portfolio risk, risk assessment, Risk Management, Total Portfolio Approach