Theory of Risk Budgeting

Richard Horwitz, Erin Simpson, Terry Smith

Risk budgeting is an integrated analytic framework with supporting management and reporting processes that provide a methodology to:

• understand risks and returns based on their fundamental sources;

• proactively manage diversification to construct robust, risk-efficient portfolios of investments; and

• constrain blow-up/tail risks.

Risk budgeting is based on the concept of allocating units of risk to specific investments, in contrast to the historical process of allocating assets. Traditionally, investors allocated 60% of their assets to equities and 40% to fixed income. Although the 60% of assets in equity represented approximately 90% to 95% of the risk of a typical portfolio (with the 40% in fixed income representing only 5% to 10% of the risk), within each of the equity and fixed-income buckets the percentage of risk allocated to each manager paralleled the related assets. However, with the ongoing growth in exposure to alternative investments (resulting from both a weak return outlook for traditional investments and the increasing acceptance of alternative investments by institutional investors) there are dramatic differences between asset allocations and risk