Risk budgeting

Some solutions say maximum overall risk should be divide between strategic and active risk, but others might say strategic, active AND structural.

1. I was always under the impression structural risk was something outside of your control, so how can you allocate anything to it?

2. If strategic risk is the systematic risk stakeholders are prepared to accept, doesn't the sum of strategic, active and structural exceed their appetite? Why is it that stakeholders decide on the systematic budget but not the active budget?

 

Hi km389,

My understanding is also that structural risk would be something outside of your control. I imagine the reason for the inconsistency is that your maximum overall risk is the sum of the three, but you would actually only choose how much risk you are taking on for active and strategic - I imagine this is decided based on how much structural risk there is likely to be.

I am not sure about your second point, but interesting question.

 

1. Structural risk arises due to the mismatch between the aggregate of portfolio benchmarks (the benchmarks which are dished out to individual managers) and the total fund benchmark (as determined by an appropriate mix for the fund). I don't think it's something that is outside your control (atleast in some simple instatnces). For example, the nature of liabilities may demand the strategic benchmark to include some exposure to equities (lets say to match real liabilities) but, what if the country the company is operating in does not have a stock exchange (very superficial example)? In this scenario, it may be decided to use other assets which may have equity like characteristics (e.g. property or private equity) as proxy for equities. So in this instance, the company will be exposed to structural risk, because it is not in a position to structure the overall fund in a way which is perfectly suitable to the liabilities and hence the aggregate of sub-portfolio benchmarks would differ from the total fund benchmark. While in this example, structural risk was brought about due to a missing assets class (i.e. listed equity) this may have been reduced by looking at foreign equity markets (just a suggestion, if possible). Similarly, I imagine there will also be instances where the company intentionally may choose to use structural risk if it believes there were gains to be made (within it's accepted risk appetite, of course).
2. I think the confusion here arises due to the interpretation of strategic risk as the systematic risk and strategic risk is not the same as systematic risk. Strategic risk (in my understanding) is merely the risk that the chosen fund benchmark (the so called strategic benchmark) performs poorly relative to the liabilities. This could be due to various reasons which include factors like

• the wrong benchmark being chosen in the first place;
• the nature of liabilities have changed whereas the fund benchmark has not been changed to match that; or
• the right benchmark was chosen and it still seems to match the liabilities well but, it just didn't do as well as we hoped it would (bad luck I guess).

To simplify the differences between the three risks and how they all add up, I'd suggest thinking of them as follow:

• Strategic risk- reflects the error the company makes in choosing its broad assets class to suit its liabilities and the chosen assets may still perform poorly, even if chosen correctly
• Structural risk - reflects the error company can make while dividing up its portfolio (could be intentional or unintentional)
• Active risk- reflects the error the individual managers can make while they chase higher returns

So if one were to think of the overall risk as a "cake" (yes, the type we eat), then:

• Strategic risk would be the risk of baking / buying the wrong cake
• Structural risk would be risk of dividing/cutting and serving the cake in a wrong way (i.e. not feeding everyone at home or leaving extra bits of the cake unserved)
• Active risk would be the risk of the individuals who got their share of the cake not eating it properly (i.e. having leftovers or eating more than they were given {not possible in the case of a piece of cake because it is finite but is very possible to do when taking financial risks})

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