Financial advisers cannot take risks with their portfolios the way hedge fund managers do. It is important for advisers to measure and control the amount of active risk allowed into their portfolios – some call this “active risk budgeting”. Efficient portfolio construction requires thoughtful active risk budgeting.
When a chief investment officer builds her strategic asset allocation, she sets the amount of risk her client is willing to take. Then she chooses the asset class exposures and weights them, using measurements such as standard deviation and beta, to fit that targeted risk.
Similarly, once you know the weight of the asset classes and it is time to fill out manager selection, the manager must set the amount of active risk she is willing to take. Then she chooses the strategies and weights them, using measurements such as tracking error, to minimize that active risk. Some call this a manager fit analysis. The purpose of a manager fit analysis is not to expel all active risk. Just as in optimising the asset classes in strategic asset allocation, the purpose of a manager fit analysis is to gain as much active return (alpha) as possible for every unit of active risk (tracking error) the client takes.
Experience has shown that a combination of active managers with a low correlation of excess returns often produces superior risk-adjusted equity portfolios than a single manager.
Active risk budgeting becomes a particularly interesting exercise when manager selection teams think about blending fundamental and quantitative strategies. Qualitatively they know that fundamental bottom-up stock pickers with concentrated portfolios have a very different investment process than quantitative, factor-based stock pickers. Intuitively, they would expect fundamental and quantitative investors to be good complements to each other. Their intuition would be right.
But many find it prudent to use more than anecdotes about process to blend managers efficiently. Some use a quantitative process as a second check on manager selection blending. In particular, one can look at the correlation of excess returns, which helps measure the diversification between two managers.
Many fund selectors use multiple managers within an asset class, but in our view many may not be combining those managers properly. If they have equal conviction in two funds, many will weight those two managers equally in the mandate. However, there is something wrong with this equation. Allocating sterling equally across two strategies taking different tracking errors results in an unequal distribution of risk in the combination.
For example, one can create two hypothetical return streams. One is a concentrated fundamental stock picker, Manager F, who takes 550 bps of tracking error and lower tracking error quantitative strategy; Manager Q takes 220 bps of tracking error, an equal sterling allocation across both strategies means that, in actuality, Manager F will dominate between 70 per cent and 99 per cent of the combination’s active risk, depending on the correlation of excess returns.
Active risk budgeting gives a better way to build multi-manager portfolios. If we have equal conviction in two managers’ ability to generate alpha with the active risk we give them, we want to give each manager an equal amount of our active risk.