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Active Risk

Updated on April 4, 2024
Article byKumar Rahul
Edited byKumar Rahul
Reviewed byDheeraj Vaidya, CFA, FRM

What Is Active Risk?

Active risk refers to the level of uncertainty or volatility associated with the returns of an investment portfolio or strategy relative to a benchmark or a passive investment approach. It measures the potential deviation in performance between the portfolio and its benchmark.

Active Risk

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It is primarily associated with actively managed investment strategies, where portfolio managers aim to outperform a benchmark index by making strategic investment decisions. These decisions may include asset allocation, sector allocation, stock selection, and buying or selling securities timing.

Key Takeaways

  • Active risk quantifies the uncertainty or volatility associated with the returns of an actively managed portfolio compared to a passive approach.
  • It is calculated using tracking error, which measures the standard deviation of the difference between portfolio returns and benchmark returns. It helps investors assess the level of risk taken by the portfolio manager in actively managing investments.
  • Managing it involves diversification, research and analysis, risk monitoring, active asset allocation, and the selection of professional portfolio managers. Investors must evaluate the risk and potential rewards associated with actively managed strategies.

Active Risk Explained

Active risk measures the volatility associated with an actively managed portfolio. It arises because active portfolio managers make investment choices that differ from the composition of the benchmark index. These choices can include overweighting or underweighting certain sectors, selecting specific stocks, or adjusting the portfolio’s asset allocation based on the manager’s research, expertise, or market outlook.

It is the potential for the portfolio’s returns to deviate from the benchmarks. It measures the level of uncertainty or volatility in the portfolio’s performance due to the active management decisions made by the portfolio manager.

Investors who allocate their assets to actively managed funds or portfolios assume this additional risk to achieve higher returns than those provided by passive investment strategies, such as investing in a broad-based index fund replicating the benchmark. However, active management also introduces the possibility of underperformance, as the manager’s decisions may only sometimes result in positive outcomes.

By assessing it, investors can gain insight into the potential variability of returns associated with an active investment strategy. Tracking error, which measures the deviation of portfolio returns from the benchmark returns, is a standard metric used to quantify such risk. Higher tracking error indicates greater active risk, while lower tracking error suggests a more closely aligned performance with the benchmark.

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Formula

The formula for measuring active risk, often expressed as tracking error, involves calculating the standard deviation of the difference between the returns of a portfolio and its benchmark. Here’s the formula:

Active Risk (Tracking Error) = Standard Deviation (Portfolio Returns-Benchmark Returns)

To calculate the tracking error, follow these steps:

  1. Gather the historical returns of the investment portfolio over a specific period. These returns represent the performance of the actively managed portfolio.
  2. Gather the historical returns of the benchmark index over the same period. The benchmark index serves as a reference point for comparison.
  3. Calculate the difference between the portfolio and benchmark returns for each corresponding period.

Difference = Portfolio Returns – Benchmark Returns

  1. Compute the standard deviation of the differences calculated in step 3. The standard deviation measures the dispersion or volatility of these differences, indicating the risk.

Tracking Error = Standard Deviation (Differences)

The resulting tracking error value represents the portfolio’s active risk level. A higher tracking error suggests a more significant potential deviation in performance from the benchmark, indicating higher active risk. Conversely, a lower tracking error means a closer alignment between the portfolio’s returns and the benchmark, implying lower risk.

Examples

Let us understand in the following ways:

Example #1

Let’s consider an investment portfolio that aims to track the performance of the S&P 500 Index. Over a given period, the portfolio returns are as follows:

Portfolio Returns:
Year 1: 8%
” 2: 5%
” 3: 10%
” 4: 6%
” 5: 9%

Now, let’s assume that the benchmark (S&P 500 Index) has the following returns for the same period:

Benchmark Returns:
Year 1: 7%
” 2: 6%
” 3: 9%
” 4: 7%
” 5: 10%

To calculate the risk, we need to calculate the difference between the portfolio returns and the benchmark returns for each year:

Active Return = Portfolio Return – Benchmark Return

Active Return:
Year 1: 8% – 7% = 1%
” 2: 5% – 6% = -1%
” 3: 10% – 9% = 1%
” 4: 6% – 7% = -1%
” 5: 9% – 10% = -1%

Next, we calculate the standard deviation of these active returns. Let’s assume the standard deviation of the active returns is 2%.

Active Risk = Standard Deviation of Active Returns

Active Risk = 2%

Therefore, in this example, the active risk of the portfolio is 2%

Example #2

In a recent article published on Seeking Alpha, the iShares Core S&P U.S. Value ETF (IUSV) was examined for its unique investment approach. The analysis highlights IUSV’s transparent value investing strategy, which aims to generate attractive returns while maintaining a balanced level of active risk.

The IUSV focuses on identifying undervalued stocks within the S&P 900 Index. The ETF uses a rules-based methodology to capture the value premium by overweighting stocks with favorable valuation metrics. This approach allows investors to gain exposure to value stocks while benefiting from a transparent and systematic investment process.

One of the critical advantages of IUSV highlighted in the article is its commitment to transparency. Investors have clear visibility into the ETF‘s holdings and portfolio construction methodology. This transparency empowers investors to assess the level of active risk the fund takes, enabling them to make well-informed investment decisions.

Furthermore, the IUSV’s ability to manage active risk effectively. While the fund seeks to outperform its benchmark index, it does so with a modest level of active risk. This balanced approach offers the potential for excess returns while managing volatility and downside risk.

IUSV’s low expense ratio is also noted as a favorable factor. The cost-effective structure of the ETF allows investors to gain exposure to a diversified portfolio of value stocks at a competitive price, enhancing the potential for long-term returns.

How To Manage?

Managing active risk involves implementing strategies and techniques to mitigate the potential deviation in performance between an actively managed portfolio and its benchmark. Here are some approaches to consider:

  1. Clearly define investment objectives: Establish clear and well-defined investment objectives that align with risk tolerance and financial goals. This includes determining the portfolio’s target return, risk tolerance level, and time horizon.
  2. Conduct thorough research and analysis: Perform in-depth research and analysis to support investment decisions. This involves analyzing fundamental data, company financials, industry trends, and macroeconomic factors. A robust research process can help identify investment opportunities and potential risks.
  3. Diversify the portfolio: Diversification is a key risk management strategy. Allocate investments across different asset classes, sectors, geographies, and securities to spread risk. By diversifying, reduce the impact of individual securities or sectors on the overall portfolio performance.
  4. Active asset allocation: Make strategic asset allocation decisions based on market conditions, valuation metrics, and economic outlook. Adjust the budget to different asset classes (stocks, bonds, and alternative investments) based on changing market dynamics to optimize risk and return potential.
  5. Focus on risk management: Implement techniques to monitor and control risk. This can involve setting risk limits, employing stop-loss orders, conducting stress tests, and continuously monitoring portfolio exposures.

Importance

Active risk management is essential for several reasons:

  1. Preservation of capital: By actively managing risk, investors aim to protect their capital from significant losses. Monitoring and controlling risk can help prevent excessive exposure to volatile securities or sectors, reducing the potential for substantial declines in portfolio value.
  2. Consistent performance: Managing such risk allows investors to strive for consistent performance relative to their objectives. Its management seeks to maintain a more stable and predictable investment outcome by closely monitoring and adjusting portfolio exposures.
  3. Risk-adjusted returns: Its management helps optimize the risk-return trade-off. By actively monitoring and managing risk, investors can seek to achieve higher risk-adjusted returns compared to a passive investment strategy. This means generating better returns for a given level of risk or achieving similar returns with lower volatility.
  4. Alignment with investment objectives: It also ensures investment decisions align with specific investment objectives and risk tolerance. By actively considering risk factors and managing them appropriately, investors can tailor their portfolios to meet their financial goals and preferences.
  5. Adaptation to market conditions: It enables investors to adapt strategies to changing market conditions. By monitoring risk factors and adjusting portfolio allocations, investors can take advantage of market opportunities, reduce exposure to potential risks, and navigate different market environments more effectively.

Active Risk vs Active Share

Some of the differences between active risk and active share are:

AspectActive RiskActive Share
DefinitionThe level of uncertainty or volatility associated with the returns of an investment portfolio relative to a benchmark or passive approach.Focuses on the extent of portfolio differentiation from the benchmark regarding holdings.
FocusFocuses on the potential deviation in performance between the portfolio and the benchmark.It is calculated by comparing the weights of individual securities in the portfolio to those in the benchmark index.
CalculationIt is calculated by comparing the weights of individual securities in the portfolio to those in the benchmark index.It is calculated by comparing the weights of individual securities in the portfolio to those in the benchmark index.
PurposeEvaluates the potential risk associated with actively managed strategies and the likelihood of deviation from benchmark performance.Measures the degree of active management and determines how distinct a portfolio is from the benchmark index.
InterpretationIt measures the potential deviation in returns, which active shares can influence.Measures the degree of active management and determines how different a portfolio is from the benchmark index.
RelationshipHigher active share suggests a more significant divergence in holdings from the benchmark, indicating a higher level of active management.Active share is one factor that can contribute to active risk but does not provide a direct measure of risk itself.
ConsiderationsHigher risk indicates a more significant potential for deviation in returns from the benchmark, indicating higher risk.Useful for investors evaluating the level of active management and the potential for the portfolio to differ from the benchmark.
Objective

Active Risk vs Residual Risk

A brief comparison between active risk and residual risk is as follows:

AspectActive RiskResidual Risk
DefinitionThe level of uncertainty or volatility associated with the returns of an investment portfolio relative to a benchmark or passive approach.Arises from factors beyond the investor’s control, such as market-wide events and systematic risk.
Source of RiskArises from active management decisions and deviations from the benchmark.Arises from factors beyond the control of the investor, such as market-wide events and systematic risk.
CalculationIt can be managed by adjusting portfolio allocations, conducting thorough research, diversifying holdings, and monitoring risk.Typically not explicitly calculated but inferred by subtracting systematic risk (measured by beta) from total portfolio risk.
MeasurementReflects the risk exposure even after achieving optimal diversification by including different asset classes and securities.Residual risk is an inherent risk that cannot be eliminated through diversification, representing the risk investors face due to market-wide factors.
InterpretationHigher risk indicates a more significant potential for deviation in returns from the benchmark, indicating the higher risk associated with active management.Residual risk cannot be eliminated through diversification but can be managed by asset allocation decisions, hedging strategies, and risk management techniques.
Risk ManagementIt can be managed by adjusting portfolio allocations, conducting thorough research, diversifying holdings, and risk monitoring.It can be managed by adjusting portfolio allocations, conducting thorough research, diversifying holdings, and monitoring risk.
Influence on ReturnsIt can impact the potential for outperformance or underperformance relative to the benchmark, as higher risk may result in greater return volatility.Residual risk affects the total risk of a portfolio. Still, it does not directly impact the potential for active outperformance, as it represents a systematic risk affecting all market investors.

Frequently Asked Questions (FAQs)

1. How does active risk differ from standard deviation?

Active risk and standard deviation are related but measure different aspects of risk. Standard deviation measures the overall volatility or dispersion of returns for an investment. At the same time, active risk focuses explicitly on the volatility or uncertainty associated with the difference between portfolio and benchmark returns.

2. What is a good level of active risk?

The appropriate level of such risk depends on various factors, including an investor’s risk tolerance, investment objectives, and the specific strategy employed. There is no universally defined “good” level of risk, as it varies based on individual preferences and goals. Generally, higher risk implies a higher potential for deviation from the benchmark, which may lead to higher returns and volatility.

3. What is the difference between active risk and tracking error?

Active risk and tracking error refer to the same concept. Both are used interchangeably to describe the potential deviation in performance between an investment portfolio and its benchmark. Tracking error is often the preferred term in academic literature, while active risk is more commonly used in the industry.

This article has been a guide to What is Active Risk. Here, we explain it in detail, including its formula and comparison with active share. You may also find some useful articles here –

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