Active Risk
Encyclopedia
In finance
, active risk refers to that segment of risk in an investment portfolio that is due to active management decisions made by the portfolio manager
. It does not include any risk (return) that is merely a function of the market's movement. In addition to risk (return) from specific stock selection or industry and factor "bets", it can also include risk (return) from market-timing decisions.
A portfolio’s active risk, then, is defined as the annualized standard deviation
of the monthly difference between portfolio return and benchmark return. Thus, an active risk of x per cent would mean that approximately 2/3 of the portfolio’s returns (one standard deviation from mean) can be expected to fall between +x and -x per cent of the mean excess return. It may be calculated as a realised, or ex post number (derived from the actual returns of a varying portfolio) or as a forward, ex ante, or predicted number (usually based on a multifactor model defining the covariance
relationships between each pair of securities in the current portfolio).
Active risk is normally called tracking error
in Europe. There is no necessary or stable relationship between ex ante and ex post tracking error. Furthermore, while tracking error measures the standard deviation of active returns, it does not measure any systematic trend in those returns.
Finance
"Finance" is often defined simply as the management of money or “funds” management Modern finance, however, is a family of business activity that includes the origination, marketing, and management of cash and money surrogates through a variety of capital accounts, instruments, and markets created...
, active risk refers to that segment of risk in an investment portfolio that is due to active management decisions made by the portfolio manager
Portfolio manager
A portfolio manager is either a person who makes investment decisions using money other people have placed under his or her control or a person who manages a financial institution's asset and liability portfolios....
. It does not include any risk (return) that is merely a function of the market's movement. In addition to risk (return) from specific stock selection or industry and factor "bets", it can also include risk (return) from market-timing decisions.
A portfolio’s active risk, then, is defined as the annualized standard deviation
Standard deviation
Standard deviation is a widely used measure of variability or diversity used in statistics and probability theory. It shows how much variation or "dispersion" there is from the average...
of the monthly difference between portfolio return and benchmark return. Thus, an active risk of x per cent would mean that approximately 2/3 of the portfolio’s returns (one standard deviation from mean) can be expected to fall between +x and -x per cent of the mean excess return. It may be calculated as a realised, or ex post number (derived from the actual returns of a varying portfolio) or as a forward, ex ante, or predicted number (usually based on a multifactor model defining the covariance
Covariance
In probability theory and statistics, covariance is a measure of how much two variables change together. Variance is a special case of the covariance when the two variables are identical.- Definition :...
relationships between each pair of securities in the current portfolio).
Active risk is normally called tracking error
Tracking error
In finance, tracking error is a measure of how closely a portfolio follows the index to which it is benchmarked. The most common measure is the root-mean-square of the difference between the portfolio and index returns....
in Europe. There is no necessary or stable relationship between ex ante and ex post tracking error. Furthermore, while tracking error measures the standard deviation of active returns, it does not measure any systematic trend in those returns.