Absolute and Relative Risk

Absolute and Relative Risk in Portfolio Management

The process of determining absolute and relative risk in portfolio management is primarily influenced by two components: the position sizing of assets or factors (whether absolute or relative), and the covariance of these assets or factors with the portfolio (again, absolute or relative). Understanding these components allows a portfolio manager to accurately calculate the contribution of each position to the portfolio’s variance or active variance. These positions could be a factor, country, sector, or security.

For instance, consider a real-world example of a portfolio manager who operates a US sector rotator strategy without regard to benchmarks. Despite this, the client will assess the manager’s performance relative to a specific benchmark, representing the universe of securities from which the manager typically selects. Given the nature of this strategy, the manager is likely to exhibit a high level of active risk.

The client, in evaluating the manager’s effective use of this risk budget, will break down the sources of realized risk. They will want to know how much of the risk is due to market risk and other risk factors, and how much is due to other decisions, such as sector and security allocation. If the manager runs a concentrated portfolio, sector and security allocation are expected to be the main sources of active risk.

Fund Style and Strategy

Understanding the style and strategy of a fund is crucial as it significantly influences the structure of its risk budget.

Investment managers often view their investment process and evaluation of securities as independent of any benchmark. However, the outcomes of these processes may align with the benchmark in key areas such as active risk. This is particularly true for multi-factor managers whose portfolio construction process often results in a balanced exposure to risk factors, thereby limiting active risk. For instance, a manager investing in both technology and healthcare sectors to balance the risk.

Active Risk in Different Strategies

A strategy like sector rotation, for example, shifting investments from technology to healthcare sector, may have a higher level of active risk, but not significantly so. The returns from this strategy are more influenced by concentrated sector and style exposures compared to the returns of multi-factor managers. These differences can impact returns over shorter timeframes. It’s important to note that two strategies with similar active risk can have very different patterns of realized returns.

Evaluating an Investment Manager

When evaluating an investment manager, asset owners need to understand the factors driving active risk as these can lead to differences in realized portfolio returns over time. The strategy and portfolio structure of a manager can be revealed by the sources of absolute risk.

Practice Questions

Question 1: A portfolio manager is running a benchmark-agnostic US sector rotator strategy. Despite the manager’s disregard for benchmarks, the client evaluates his performance relative to a specific benchmark. The manager’s strategy is likely to exhibit a high level of active risk. In evaluating the manager’s effective use of this risk budget, the client decomposes the sources of realized risk. In this scenario, if the manager runs a concentrated portfolio, which of the following is expected to be the main source of active risk?

1. Market risk
2. Sector and security allocation
3. Covariance of assets

Answer: Choice B is correct.

The main source of active risk in a concentrated portfolio run by a portfolio manager using a benchmark-agnostic US sector rotator strategy is likely to be Sector and Security Allocation. Active risk, also known as tracking error, is the risk that a portfolio’s performance will deviate from its benchmark. In a concentrated portfolio, the portfolio manager makes significant bets on specific sectors and securities, which can lead to substantial deviations from the benchmark. This is especially true in a sector rotator strategy, where the manager actively shifts the portfolio’s exposure to different sectors based on their expected performance. Therefore, the sector and security allocation decisions made by the manager are likely to be the main source of active risk in this scenario. These decisions can lead to significant differences in the portfolio’s performance compared to the benchmark, especially if the manager’s sector and security selections do not perform as expected.

Choice A is incorrect. Market risk, also known as systematic risk, is the risk that affects all securities in the market, not just a specific sector or security. While market risk can contribute to active risk, it is not likely to be the main source of active risk in a concentrated portfolio run by a portfolio manager using a benchmark-agnostic US sector rotator strategy. This is because the manager’s sector and security allocation decisions, not market-wide factors, are likely to be the primary drivers of the portfolio’s performance relative to the benchmark.

Choice C is incorrect. The covariance of assets, or the degree to which the returns of different assets move together, can also contribute to active risk. However, in a concentrated portfolio run by a portfolio manager using a benchmark-agnostic US sector rotator strategy, the manager’s sector and security allocation decisions are likely to be the main source of active risk. This is because these decisions can lead to significant deviations from the benchmark, especially if the manager’s sector and security selections do not perform as expected.

Question 2: A portfolio manager is managing a portfolio with a variety of positions, including factors, countries, sectors, and securities. The determination of absolute and relative risk is influenced by the position sizing of these assets or factors and their covariance with the portfolio. Which of the following can accurately determine the contribution of each position to the portfolio’s variance or active variance?

1. Only the position sizing of assets or factors
2. Only the covariance of these assets or factors with the portfolio
3. Both the position sizing of assets or factors and the covariance of these assets or factors with the portfolio

Answer: Choice C is correct.

The contribution of each position to the portfolio’s variance or active variance is accurately determined by both the position sizing of assets or factors and the covariance of these assets or factors with the portfolio. Position sizing refers to the amount of a particular asset or factor in the portfolio. It is a crucial aspect of portfolio management as it determines the potential impact of an individual asset or factor on the overall portfolio. Covariance, on the other hand, measures the degree to which two variables move in relation to each other. In the context of portfolio management, it is used to understand how the returns of an individual asset or factor move in relation to the returns of the overall portfolio. Therefore, both position sizing and covariance are necessary to accurately determine the contribution of each position to the portfolio’s variance or active variance. This understanding is crucial for effective risk management and for making informed investment decisions.

Choice A is incorrect. While the position sizing of assets or factors is an important aspect of determining the contribution of each position to the portfolio’s variance or active variance, it is not sufficient on its own. Without considering the covariance of these assets or factors with the portfolio, the portfolio manager would not have a complete understanding of the potential risk associated with each position.

Choice B is incorrect. Similarly, only considering the covariance of these assets or factors with the portfolio would not provide a complete picture of the contribution of each position to the portfolio’s variance or active variance. Without considering the position sizing of these assets or factors, the portfolio manager would not be able to accurately assess the potential impact of each position on the overall portfolio.

Glossary

• Portfolio Variance: A measure of the dispersion of returns of a portfolio.
• Weights of Assets: The proportion of each asset in a portfolio.
• Standard Deviation of Returns: A measure of the amount of variability or dispersion around an expected return.
• Correlation Coefficient: A measure that determines the degree to which two variable’s movements are associated.
• Sector Rotation: An investment strategy involving moving investments from one industry sector to another.
• Multi-factor Managers: Investment managers who diversify their investments across multiple factors to reduce risk.

Portfolio Management Pathway Volume 1: Learning Module 3: Active Equity Investing: Portfolio Construction;

LOS 3(g): Discuss the application of risk budgeting concepts in portfolio construction. Discuss risk measures that are incorporated in equity portfolio construction and describe how limits set on these measures affect portfolio construction