Risk Budgeting for Active Investment Managers

Robert Litterman, Jacques Longerstaey, Jacob Rosengarten and Kurt Winkelmann

In most investment contexts the returns portfolio managers create are compared to those of an index of the returns of the relevant market. This is a reasonable standard if the relevant index returns are available to the client at relatively low cost. In this context tracking error¹¹“Tracking error”, usually measured in basis points, refers to the annualised volatility of the returns of a portfolio relative to its benchmark. In some cases a portfolio may not have an explicit benchmark, or the benchmark may be a risk-free rate; in those contexts tracking error refers to the volatility of the excess returns relative to the risk-free rate. measures the relevant risk – the risk relative to such a benchmark – that the portfolio manager is taking in order to add excess return. Clients have a responsibility as well not only to discuss risk expectations about the absolute returns of a portfolio, but also to provide clear guidance about how much risk relative to a benchmark (sometimes referred to as “active risk”) they expect the portfolio manager to take.

Why do we need a green zone?²²The concept of attributing a colour coding to define ranges in risk management was first coined by those