Idiosyncratic risk is defined as the variation in (excess) returns that cannot be explained by systematic risk factors. In portfolios that are managed against a benchmark index, it results from active deviations from the index compositions. Large deviations from benchmark weights make a portfolio vulnerable to credit events for a particular issuer. In general, the broader a portfolio is diversified, the less it is exposed to idiosyncratic risk.

Therefore, issuer-specific risk is often called a diversifiable risk. When portfolios are managed in an absolute-return fashion, over- or underweights relative to a benchmark index clearly do not matter. Risk is caused by the absolute exposure to a certain issuer. This is particularly true for structured credit products like collateralized debt obligations (CDOs), as we have pointed out earlier.