Risk budgeting

[Frances]

Hi,

I am a bit confused about risk budgeting. There is a lot of reference to the strategic benchmark - is this the benchmark that is derived assuming we want to match liabilities in the long term?

Also, could someone please explain to me structural risk - is this the same as lack of diversification across different funds due to investing in assets that are highly correlated, so therefore the risk is greater than the strategic benchmark?

I think what I am finding difficult is that I am trying to get my head around how you would split up the strategic benchmark into the individual benchmarks for each fund - how would this work?

Thanks,

Fran

 

[Lindsay Smitherman]

Hi Frances

The strategic benchmark relates to the mix of asset types within the fund. The company could start from a matched portfolio (i.e. assets matched to liabilities), but could then choose to mismatch to some extent within its strategic benchmark in order to make higher returns.

A fund may consist of a number of different asset portfolios and each of these could require a separate specialist investment manager. Each of these managers is given a benchmark for their particular portfolio (i.e. sub-part of the fund). For example, the investment manager responsible for investing in equities in country X may be expected to beat the performance of the stockmarket index in country X. For practical reasons, the aggregate of the separate benchmarks across all of the specialist investment managers may not equate precisely with the overall benchmark set for the fund. This results in structural risk: the risk associated with a mismatch between the aggregate of the portfolio benchmarks and the total fund benchmark.

For example, a strategic benchmark may require some property investment but a fund may be too small to employ a property fund manager and so will be exposed to structural risk.

Benchmarking that relates to peers (or "competitive benchmarking") also increases structural risk, as the investment strategy of the peer group will not be known at the point at which benchmarks are allocated to each of the investment managers.

Hope that helps: structural risk is not about diversification but more about the practical separation of the overall fund into portfolios allocated to different investment managers.

 

[Frances]

I think the penny has just dropped! Thank you Lindsay.

 

[Frances]

For structural risk - when we say the sum of the individual benchmarks does not add to the strategic benchmark, do we mean e.g. 10% of the fund invested in property is the strategic benchmark for property, but because no property fund manager there is actually 0% invested in property and it's this difference that gives rise to the structural risk?

Thanks

 

[Frances]

I think what has been confusing me is the multiple references to different benchmarks - e.g. structural benchmark, which is going to be different from the benchmark that each specialist investment manager has when we speak about active risk! I am just trying to understand what benchmark we are referring to for structural risk, if that makes any sense?!

Thanks

 

[Mark Willder]

For structural risk - when we say the sum of the individual benchmarks does not add to the strategic benchmark, do we mean e.g. 10% of the fund invested in property is the strategic benchmark for property, but because no property fund manager there is actually 0% invested in property and it's this difference that gives rise to the structural risk?

Thanks

Yes, that's right. So we might end up with an extra 10% in equities instead of property.

Best wishes

Mark