Active risk budgeting in action

In the example above, suppose Manager F and Manager Q have a very low correlation of excess returns of 0. To make sure each manager is contributing equally to active risk/tracking error, we can weight Manager F at 30 per cent of the portfolio and Manager Q at 70 per cent of the portfolio. The noteworthy result: this blend has a lower tracking error than either Manager F or Manager Q individually.

Even better, once we have reduced our blended tracking error, our information ratio – meaning how efficient we are being with every unit of active risk we take – is also higher than the same metric for either of our two managers individually.

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While the example above is for a blend of two funds, the principles involved in evaluating manager fit are as true for a mandate of two funds as for a mandate of four (or more) funds. 

At Goldman Sachs Asset Management, we find that running this type of manager fit analysis is most impactful after identifying a short list of funds run by trusted managers whose process is well understood. In other words, we think this analysis serves best not as an initial screen, but as a final selection and sizing tool. Because past performance does not always indicate future success, many investment officers want strong conviction in their managers and their processes before relying on past return streams to make these sorts of judgments about future allocations. 

A great benefit of the return of quant is the ability of manager selection teams to add alpha in a complementary way to existing fundamental equity mandates. Some use a manager fit analysis incorporating tracking error, correlation of excess returns, and information ratio to add an objective process to fund selection and weighting methodology.

The goal in doing so is to avoid putting the client at risk for blown expectations, and to be as efficient as possible with the risk the client has entrusted with the manager. 

Brendan McCurdy is executive director, portfolio strategy Emea, strategic advisory solutions of Goldman Sachs Asset Management

Key points

It is important for advisers to measure and control the amount of active risk allowed into their portfolios.

Many fund selectors use multiple managers within an asset class.

Active risk budgeting gives us a better way to build multi-manager portfolios.