Bridge over ocean
1 September 2006 Financial Analysts Journal Volume 62, Issue 5

The Sense and Nonsense of Risk Budgeting

  1. Arjan B Berkelaar, CFA
  2. Adam Kobor, PhD, CFA
  3. Masaki Tsumagari

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.

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