Budgeting Risk along the Active Risk Spectrum 199 In summary, the empirical information ratio advantage for structured managers
reflects two methodological advantages: (1) their relative freedom from the no-short constraint (due to smaller intended active deviations) and (2) their greater focus on risk management (and the related reduction in noise in the information ratio's denominator). If these conventions persist in the future, then we would expect the information ratio advantage to persist as well. Given the historical information ratio advantage of structured managers, investors might conclude from our discussion that they should allocate little, if any, of their active risk budgets to traditional active strategies. This is not necessarily the case. There are at least two good reasons to include traditional managers in the mix. First, despite the reasons noted, the information ratio advantage for structured managers may not persist. Historical information ratios are poor predictors of future performance, and especially so for comparatively small samples such as ours. Our sample uses quarterly data and has a relatively small number of structured managers. Consequently, we should regard our statistical results as suggestive rather than definitive.4 Prudent diversification, then, argues for using managers at both ends of the active risk spectrum. Second, at least some traditional managers have added value historically, and their performances were relatively uncorrected with structured managers, suggesting that investors can improve their expected information ratios by allocating at least some of their active risk budgets to traditional strategies. Thus, the real issue is the size of the allocation to each active strategy, both relative to one another and relative to the passive allocation. FINDING THE RIGHT MANAGER MIX How should investors allocate assets between active and passive strategies? Should they adopt a barbell approach or take risk across the entire active risk spectrum? Whatever approach they ultimately adopt, investors should carefully evaluate the trade-offs that accompany each key decision. As discussed in the preceding chapter, we believe the best way to assess these trade-offs is through an analysis of the active risk budget.5 There are three important concepts to clarify about active risk budgeting: (1) the active risk budget, (2) the optimal active risk budget, and (3) the active risk budgeting process. An active risk budget is simply an attribution of active risk to its constituent parts. Suppose, for example, that an investor has six domestic equity managers with different levels of active risk. Armed with estimates of the correlations between managers, it is quite straightforward to calculate the tracking error of the portfolio of managers relative to the combined benchmark, and then attribute the total equity tracking error to each of the six managers. This decomposition is the active risk budget. 4The t-statistic on the difference between median information ratios for portfolios of four structured and traditional managers is 1.72, which is significant at the 11 percent level. 5The active risk budget analyzes the effects of deviations from the strategic benchmark.
Read also about: return money investment investing money hand
