Absolute vs Relative Risk and Policy Mix vs Active Risk

AIM 75.7: Explain absolute versus relative risk and distinguish between policy mix and active risk for investment managers.

Absolute or asset risk refers to the total possible losses over a horizon. It is simply measured by the return over the horizon. Relative risk is measured by tracking error, which is the dollar loss relative to a benchmark. The shortfall is measured as the difference between the fund return and that of a benchmark in dollar terms. VAR techniques can apply to tracking error if the tracking error is normally distributed.

Distinguishing policy mix from active risk is important when an investment firm allocates funds to different managers in various asset classes. This breaks down the risk of the total portfolio into that associated with the target policy (i.e., the weights assigned to the various funds in the policy) and the risk from the fact that managers may make decisions which lead to deviations from the designated weights. VAR analysis is especially useful here because it can show the risk exposure associated with the two types of risk and how they affect the overall risk of the entire portfolio. Often, active management risk is not much of a problem for several reasons:

• For well-managed funds, it is usually fairly small for each of the individual funds.

• There will be diversification effects across the deviations.

• There can be diversification effects with the policy mix VAR to actually lower the total portfolio VAR.

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