Risk Budgeting

[Batsirai Kapembeza]

Hello everyone,

The Core Reading in Chapter 22: Portfolio Management (2) states as an example;

"So, the 5% pa total allowable tracking error (the risk budget) will first need to be allocated between strategic risk and total active risk."

This is with reference to risk budgeting.I wanted to find out, how is this actually done practically?. I know what strategic risk is and what active risk is and I understand those two concepts completely, but I am struggling with understanding how tracking error for example can practically be allocated between these two.

Thank you.

 

[Joe Hook]

Hi,

Someone else may be able to weigh in on this if they practical experience here (which unfortunately I don't) but my guess would be:

You would divide your risk budget into strategic risk and active risk and then build a model to calculate forward-looking tracking error.

Then run various investment strategies through your model and calculate the forward-looking tracking error of each and compare with your strategic risk budget. Then, once the investment strategy is decided, appoint investment managers whose level of active risk was broadly in line with the level of your active risk budget; possibly including this target active risk in the manager's mandate.

For example, if you chose a strategic benchmark and ran the model you might get (say) 5% tracking error with your liabilities. Then agree level of active risk with your manager of (say) 3%. When you run the model with both risks modelled, you might get close to 8% total tracking error expected between the active portfolio and the liability benchmark. Thus the 8% total tracking error has been split between strategic and active risk.

Joe

 

[Batsirai Kapembeza]

Thank you, it makes much more sense now.