Investment Theory and Risk Management, + Website

Summary

Risk budgets force us to control the level of risk, and to budget that risk across assets in the portfolio. In this chapter, I tried to illustrate this task in a world in which managers have views about forward returns that may differ from the historical record. Fisher Black and Robert Litterman provide a method that mixes observed returns and risks from historical data with managers’ beliefs in an optimal way. I then complicate this picture by introducing active portfolio management in which managers deviate from an established passive portfolio (the so-called benchmark portfolio) in their effort to produce an active return to their perceived skill. However, active management is not without its constraints; therefore, I show how principals such as trustees of funds restrict managements’ departure from the benchmark allocation by imposing a risk budget. The result is that managers are allowed to take on tracking error (active risk) but the amount and allocation of this risk is now evident not only to them (agents) but to their principals as well. Risk budgets have profound implications on the amount of tracking error managers take. Trustees therefore may find that they can control agents through risk budgets and locate active risk sensitivities in the optimal allocation to small deviations in active weights within the risk budget.