Risk Management: Foundations for a Changing Financial World

CHAPTER 18

THE SENSE AND NONSENSE OF RISK BUDGETING^r

Arjan B. Berkelaar, CFA, Adam Kobor, CFA, and Masaki Tsumagari, CFA

A framework is described for the optimal allocation of active risk among broad asset classes or external asset managers. Unlike most risk allocation models used by practitioners, this framework does not assume that cross-correlations are zero. An analytical expression for the optimal allocation of tracking error among investment decision areas (assets and external managers) in the presence of correlations is provided. The key to understanding optimal risk allocation is the correlation-adjusted information ratio, a novel concept introduced in this article. Also discussed are various approaches to setting realistic input assumptions, such as the expected IR, for deriving optimal risk allocation.

Risk budgeting is on the minds of many institutional investors. A few years of dismal equity returns and decreasing bond yields have left many pension funds underfunded. What is worse, the outlook for equity and bond markets for the next 10 years is not as rosy as it was in the early 1990s. Many institutional investors are now desperately searching for diversification and return-enhancing strategies. Institutional investors can no longer simply rely on market returns to stay abreast of liabilities. Returns need to be milked to squeeze out every bit of alpha available. As a result, investors need to deviate from benchmarks and introduce active risk into their portfolios. ...