A framework is described for the optimal allocation of active risk among broad
asset classes or external asset managers. Unlike most risk allocation models
used by practitioners, this framework does not assume that cross-correlations
are zero. An analytical expression for the optimal allocation of tracking error
among investment decision areas (assets and external managers) in the presence
of correlations is provided. The key to understanding optimal risk allocation is
the correlation-adjusted information ratio, a novel concept introduced in this
article. Also discussed are various approaches to setting realistic input
assumptions, such as the expected IR, for deriving optimal risk allocation.