Video: CIO Lens Q3 2026 - "The challenge is understanding where risks accumulate"
In this quarter's CIO Lens, Johanna Kyrklund reflects on the importance of knowing how exposures fit together in a portfolio.
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Watch Johanna’s latest video by clicking on the play button above and read the full column below.
At the end of last year, I highlighted three risks we had to watch: the credibility of the Federal Reserve, debt sustainability and AI. Where have we got to?
Central bank credibility intact for now
First, bonds. Confronted with a more populist turn in policy in recent years, we have consistently been of the view that more profligate fiscal policies would boost nominal growth and, by extension, corporate earnings. The ultimate constraint on this trend would be the extent to which bond investors would be willing to fund government spending.
For now, news on this front has been comforting for me. We saw a sell-off in bond yields in the second quarter driven by concerns about energy-induced stagflation but yields are back at fair value, rate expectations are more realistic, and an easing of tensions in the Middle East has alleviated the risk of inflation in the short-term.
Central banks have shown a willingness to “tap on the brakes” by raising rates and, for now, new Federal Reserve (Fed) Chair Kevin Warsh’s policy pronouncements have indicated that he understands the importance of maintaining the credibility of the Fed.
Some commentators have been concerned about the step away from dot plots and forward guidance, but I view this as a sensible adjustment in a world of more frequent supply shocks and a return to the more pragmatic policies of the 1990s and 2000s. After all, the dot plot was only introduced in 2012.
The challenge of achieving real diversification in equities
What about equities? Here we are starting to see more extreme behaviour and expensive valuations. A lot is made of the concentration of the index but this misses the point slightly. In fact, compared to previous years, equity performance has been less dominated by the Mag 7; indeed, the Mag 7 in aggregate has been flat year to date.
Concentration has actually been a much bigger issue in terms of index contributions: this year, 20 stocks in MSCI ACWI have accounted for 74% of the return of the entire index with AI-related sub sectors such as memory being key drivers of this trend. Markets are chasing any capital equipment company with an AI datacentre angle, and in many cases, capitalising these earnings with high multiples.
Furthermore, exposure to the AI theme extends into private markets and, increasingly, part of the credit markets. That means that portfolios may be less diversified than asset class labels would imply. This is a key concern for our investors. Our latest Global Investor Insights Survey found that diversification is a top portfolio objective for 84% of respondents. How should investors manage this risk?
Several clients have asked me about allocating to equal cap weighted indices as a way of reducing concentrated exposure to AI. I fear that this tool is too blunt. Stock specific risks associated with concentrated contributions to return may not be effectively hedged with unrelated, arbitrarily selected stocks. Equal-weighting can introduce unintended stylistic tilts - such as weaker balance sheets, higher leverage, greater rate sensitivity, more volatile earnings, lower profitability and reduced liquidity.
Whilst some investors might see opportunities in such exposures, increasing weights to these stocks as a means of diversifying away from AI risks may lead you to what I call “the old lady who swallowed a fly” problem. This is a nursery rhyme which highlights absurd consequences which result from blunt or inappropriate solutions to an initially simple problem.
At this point, I would favour style diversification as a means of managing AI risk and increasing the resilience of one’s portfolio. Here recent trends have been extreme. Over 12 months, Momentum is up 33% vs 17% for Quality and 21% for Value.
High quality businesses are now trading at valuations that appear attractive relative to their own history. The catalyst for this disconnected pricing is a pervasive fear of change and disruption by generative AI and the new competition it enables. The market is currently pricing very low growth into many exceptional companies, but history and our own fundamental analysis suggest that in many cases this fear is unwarranted.
At the same time, active approaches to Value provide diversification to the AI theme. A disciplined Value selection process will steer investors to precisely where peak market euphoria is not. Beware passive Value indices, however, as the AI theme has infiltrated some of the traditional value sectors such as utilities and real estate as well.
Where are risks accumulating?
I was at lunch with friends recently, and everyone was asking me about SpaceX. My investment advice is always dull - I believe in the compounding of returns and the careful balancing of risk and return through time so there's no point coming to me for "exciting" stock tips.
I'm even more boring today: investors face a world where market concentration is high, economic exposures are increasingly interconnected and valuations are stretched. The challenge is not simply finding opportunities but understanding where risks accumulate. It is more important than ever to understand what you own, how these exposures fit together and what role each exposure plays in your portfolio.
With low chance of recession and stable yields, we still see upside in equities, but my suggestion for the summer is to lean back from some of the frothiest parts of the equity market, diversify your equity risk, and wear sunscreen.
Glossary:
Mag 7 refers to a group of seven megacap technology companies: Alphabet (Google), Amazon, Apple, Meta (Facebook), Microsoft, Nvidia, and Tesla.
Equal-weighted index is a stock market index where every company is assigned the same weight, regardless of its total size, and therefore has an equal influence on the index’s overall returns. This contrasts with traditional market-cap weighted indices where mega-cap stocks dictate performance.
Momentum investing is a strategy focused on buying assets that are performing well and selling those that are lagging.
Quality stocks are those with attributes such as competitive advantages, strong balance sheets, and proven management teams.
Value stocks are those that trade on cheap valuation metrics, typically low multiples of their profits or assets, for reasons which are not justified over the longer term.
Footnote: "There was an old lady who swallowed a fly" is a nursery rhyme which illustrates the dangers of escalating errors and "digging your own hole". It warns children that when you try to solve a small, manageable problem with an extreme or inappropriate solution, you create a chain reaction that compounds the issue and makes it much worse.
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