TOPIC 8 : Risk Budgeting and Management Flashcards
(15 cards)
What is risk budgeting?
The process of allocating total portfolio risk to different sources of risk and return (such as SAA, TAA, and investment selection).
Why is risk budgeting challenging in multi-asset portfolios?
There are many variables (different sources of risk, different investment horizons, correlations) and portfolio conditions constantly change.
Why is total portfolio risk typically presented as tracking error?
It shows deviations from benchmark; it’s a convenient measure to control portfolio risk while allowing for active decisions.
Why do we need a range for tracking error?
Market conditions fluctuate, making it hard to match a single, static number. A range lets managers respond to opportunities while staying within policy bounds.
How is total risk divided in multi-asset portfolios?
Into:
✅ SAA (strategic allocation)
✅ TAA (tactical allocation)
✅ Security Selection (active fund choices)
Quantitative Approach — Main Ideas?
✅ Allocate risk to components to maximize Information Ratio
✅ Uses expected alphas, tracking error, correlations
✅ Highly sensitive to subjective assumptions
✅ May produce portfolios close to the benchmark if Information Ratio maximisation dominates
Practical Approach — Main Ideas?
✅ Set SAA, TAA, and Selection tracking error separately
✅ Combine these to total risk
✅ Allows discretion and judgment alongside data
✅ May reflect fund conviction and market conditions more accurately
4-step Practical Approach?
1️⃣ Determine SAA tracking error
2️⃣ Determine TAA tracking error
3️⃣ Determine Selection tracking error
4️⃣ Combine and check total against policy; if necessary, iterate
Why consideration of fund conviction?
Higher conviction in fund’s ability to outperform means we can take more risk by allocating more to active strategies.
Why do we need to account for transaction costs?
To avoid needless trades when the cost of reallocating risk may outweigh potential benefits.
What is the efficient frontier slope?
It shows additional return expected per additional unit of risk — the risk premium.
Why does slope matter in risk budgeting?
✅ Steep slope = high risk premium → worth taking more risk
✅ Shallow slope = low risk premium → cut back risk
Why is SAA typically first in risk allocation?
✅ SAA often drives portfolio’s return-risk profile
✅ Investor conviction in long-term signals is higher than short term
What conditions justify adding more risk?
✅ Attractive valuations (high expected return)
✅ Large dispersion in asset returns
✅ Low correlations (more diversification benefits)
✅ Steep efficient frontier (high risk premium)
Final consideration in risk budgeting?
To match total portfolio risk to policy and return goals while adding risk where it is expected to be most rewarded.
