Risk Budgeting: Investment Cruise Control for Your Clients

Gilkeson, James H.; Michelson, Stuart E.
November 2005
Journal of Financial Planning;Nov2005, Vol. 18 Issue 11, p64
Academic Journal
Risk budgeting is a process, recently adopted by many institutional investors, that limits the extent to which a portfolio can deviate from a benchmark in order to maximize expected alpha while not exceeding a predetermined acceptable tracking error. This article demonstrates how this process can be adapted for use by individual investors and their advisors who want to improve an indexing strategy, but within limits. First, the investor chooses a passive, long-term benchmark portfolio. The investor then must have good cause to deviate from that benchmark, such as a tactical modification due to current economic or investment conditions or because the investor believes he or she can select superior assets or managers within an asset class. Next, the investor determines what will be the maximum acceptable tracking error--the pattern of variation from the benchmark return. Excess return opportunities are identified and a portfolio is built that deviates from the benchmark. Risk budgeting can be easily used to aid the asset allocation decision, but it is more difficult to apply to security selections at the individual investor level due to the sheer volume of calculations and lack of evidence that alphas produced by mutual fund managers are positively related to the tracking errors of their funds. Risk budgeting is not the same thing as the value-at-risk methodology commonly used by institutional investors.


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