Managing Emerging Systemic Risks

Diversification Isn’t Enough

Modern portfolio theory established diversification as the cornerstone of risk management. Yet the evidence consistently tells a more complicated story. Research by Jon Lukomnik – co-author of Moving Beyond Modern Portfolio Theory: Investing That Matters with James Hawley – found that 75 to 90 percent of long-term investment returns are determined by market-wide performance, not individual security selection. No matter how well-constructed a portfolio is, if the broader system is impaired, risks cannot be fully mitigated.

The tools pension plans typically rely on to manage risk have demonstrated vulnerability in recent years as systemic shocks have laid bare the limitations of solely relying on diversification to manage for returns. The 2008 Global Financial Crisis, for example, exposed how excessive leverage and opaque financial instruments created risks that diversification strategies and regulatory oversight could not protect against. The COVID-19 pandemic exposed the fragility of global supply chains. Escalating geopolitical tensions have redrawn trade relationships and destabilized energy markets. Today, these disruptions are more commonplace and symptomatic of a financial environment in which systemic risks are structural.

The challenge for pension plans is how to best mitigate risks when diversification is no longer effective or adequate.

What is System-Level Investing?

System-level investing is an emerging approach that recognizes the deep interdependence between financial returns and the health of broader social, environmental and economic systems. As the Principles for Responsible Investment (PRI) articulates in its Legal Framework for Impact:

“. Investors increasingly recognise that financial returns depend on the stability of social and environmental systems, especially in the long term.”

This approach represents an evolution of sustainable and responsible investing. While traditional environmental, social and governance (ESG) frameworks manage risk at the individual asset level, system-level investing addresses risks across entire portfolios – ones that cannot be screened or diversified away from.

The Investment Integration Project (TIIP) has been a leader in developing and documenting system-level investing practices since 2015. Drawing on research with institutional investors globally, TIIP identifies three techniques that system-level investors use beyond conventional portfolio management:

1. Capital allocation to direct resources toward healthier systems
2. Active stewardship and engagement to influence industry behaviour through engagement and voting
3. Policy and advocacy to shape the regulatory and market conditions on which long-term returns depend

Systems-level investing is gaining momentum. TIIP’s 2024 analysis of five leading investors – including CalSTRS, Canada’s University Pension Plan (UPP), and Wespath Benefits and Investments – found that all five had formally embedded system-level considerations into their investment beliefs, treating the health of financial, social, and environmental systems as a prerequisite for long-term returns.

Large pension funds are well-positioned to lead this shift as universal owners hold broadly diversified portfolios across the entire economy. Large pensions both depend on healthy systems and have meaningful influence over them given the scale of their portfolios and reach of their stewardship activities.

Addressing Fiduciary Duty

In tandem with modernizing approaches to risk management, concepts of fiduciary duty are also evolving. For example, the PRI’s Legal Framework for Impact concludes:

“While financial return is generally regarded as the primary purpose and goal of investors, investors are likely to have a legal obligation to consider pursuing sustainability impact goals where doing so can contribute to achieving their investment objectives.”

Three dimensions of fiduciary duty directly align with the objectives of system-level investing:

• The duty of prudence calls for investors to have a forward-looking, process-oriented, and dynamic method of assessing all relevant material facts. Systems-level investing empowers investors with the ability to evaluate more fulsome information when assessing material risks and opportunities
• The duty of loyalty requires acting solely in the interests of beneficiaries and avoiding conflicts that could compromise responsibility to them. For pensions exposed to the entire market, that means managing for systemic risks that cannot be addressed through diversification alone, and whose neglect ultimately harms the beneficiaries they serve.
• The duty of impartiality means balancing both short-term needs with the ability to build towards long-term capital growth. Systemic risks, if left unmanaged, erode the long-term value that is intended to be generated through short-term performance management

Leading pensions have already drawn this connection explicitly in the areas of climate change and inequality.  

Example 1 – Climate Change as a Blueprint

Climate change offers the clearest example of a systemic risk that has been integrated into investment practice, and it can act as a template for addressing others.

Physical risks – extreme weather, rising sea levels – and transition risks – evolving policy, shifting consumer behaviour – do not stop at the level of an individual company or asset class. They affect entire portfolios and markets. Leading pension investors have responded by setting net-zero commitments, joining initiatives such as Climate Action 100+ and the Net Zero Asset Owner Alliance, integrating climate transition pathways into capital allocation, and advocating for enhanced transparency through disclosure standards developed by the International Sustainability Standards Board (ISSB).

CalSTRS – the second-largest public pension fund in the U.S. with USD 315 billion in assets frames system-level stewardship not as a values choice, but as a fiduciary requirement. CalSTRS’s revised their investment beliefs to formally state that climate change materially impacts portfolio value and commit the fund to use its influence as a significant global investor to drive long-term value creation through sustainable business practices and public policies.

Acting on that belief, CalSTRS committed over $30 billion in public equities and $4.4 billion in private markets to low-carbon strategies. An independent review of CalSTRS’ efforts to shift 20% of its public equity portfolio to a low-carbon index, concluded that it is entirely possible for a prudent investor to shift away from fossil fuels while still meeting investment targets.

The fund also participates in Climate Action 100+, has advocated for climate disclosure regulation, including California’s landmark climate reporting requirements, and actively uses its influence as a large asset owner to drive policy changes that protect the long-term value of its portfolio. Its strategy reflects a clear insight: reducing systemic climate risk benefits their entire portfolio in ways that no amount of asset level optimization can replicate.

Example 2 – Inequality as the Next Frontier

Economic inequality is gaining recognition as the next major systemic risk. The World Economic Forum’s (WEF) Global Risks Report 2026 ranks inequality seventh in severity over both the short and long term. Notably, the WEF also identifies inequality as the most interconnected global risk for the second consecutive year, meaning its effects amplify virtually every other risk on the list.

The financial logic is straightforward. Research from the IMF, US Federal Reserve, G20 Extraordinary Committee on Global Inequality and others highlights how persistent inequality erodes consumer demand, constrains economic growth, heightens political instability, and increases the frequency and severity of economic shocks. Labour rights violations disrupt supply chains and create regulatory and reputational exposure across portfolios. These are not abstract concerns. They are already being reflected in market volatility.

According to Statistics Canada, labour disputes resulted in 6.6 million lost workdays in 2023 – the highest in nearly four decades. For example, the Greater Vancouver Board of Trade estimated the 13-day strike at BC ports in 2023 resulted in CAD 10.7 bn worth of trade being disrupted across sectors and industries including agriculture, energy, and manufacturing.

Canada’s University Pension Plan (UPP) is at the forefront. In 2024, UPP published its Inequality Stewardship Plan – a dedicated framework for managing the financial impacts of inequality as a systemic risk. Emerging frameworks being developed by groups like the Task Force on Inequality-related Financial Disclosures (TISFD), are beginning to provide investors with structured ways to measure and report on these risks.

In Canada specifically, asset owners are driving capital towards affordable housing, recognizing that systemic housing unaffordability suppresses the consumer demand and workforce participation that their broader portfolios depend on. On the stewardship side, over 250 institutional investors representing USD 35 tn in assets have joined PRI Advance, a coordinated system-level engagement initiative that holds companies accountable on assessing equitable labour rights and human rights practices during due diligence.

Inequality, like climate, can be addressed – but only by investors who recognize it as a system-level issue, not a company-level one.

The Canadian Leadership Opportunity

Canada’s pension system has long been internationally recognized for its governance, scale and long-term orientation. The Canadian Pension Fund Model – defined by professional in-house management, long investment horizons and diversified asset allocation – is widely cited as a global standard for converting contributions into secure, lifetime retirement income. Evolving the practices to adopt a system-level investing approach is a great opportunity to continue leading the pension model.

Canada’s largest funds collectively hold assets across virtually every sector of the global economy. This is why systemic risks require both leadership and governance excellence. As disclosure standards, beneficiary expectations and growing systemic financial issues continue to evolve, the question for Canadian pension plans is not whether to engage, but how quickly and how well.

There are several concrete actions that Canadian pensions can begin taking today:

1. Build board awareness – Systemic risk is a governance issue, not only an investment one. Boards need literacy to understand if and how they connect to fiduciary duty and act accordingly.
2. Embed systemic risks into investment beliefs – Formally articulate that systemic risks are material and relevant to fiduciary obligations.
3. Integrate system-level considerations into manager selection – Evolve ESG assessments to ask managers explicitly how they identify, measure and manage risks that operate at the market level, not just the company level.
4. Evolve stewardship beyond the company level – Participate in coalitions such as PRI, Business Future Pathways, Climate Engagement Canada, PRI Advance and others that work to improve system-wide outcomes.
5. Pursue policy advocacy – Engage with regulators, securities administrators and standard-setters on frameworks such as CSDS and TISFD.

Moving Forward

For Canadian pension funds, the opportunity is real and the tools are improving. Systemic risks – from climate to inequality to geopolitical fragmentation – are not future concerns. They are present ones. Pensions that develop the capacity to recognize, evaluate and manage these risks alongside traditional investment approaches will be better positioned to protect long-term returns and fulfil their obligations to members.

The systems pension beneficiaries will retire into are shaped by investment decisions made today. And the returns those investments generate depend on those systems remaining healthy. System-level investors understand that dynamic, and are acting on it.