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FRM Part II · FRM Exam Part II · VaR and Risk Budgeting in Investment Management

A pension fund sponsor sets a total active risk budget of 4% tracking error for its equity program and allocates it across three external managers. Which statement best describes the purpose of this risk budgeting step?

Risk budgeting allocates a limited total active risk, such as tracking error, to the managers or strategies where it is expected to add the most value. It does not guarantee outperformance, remove monitoring, or make total VaR equal to the sum of stand-alone VaRs.

  1. AIt allocates the limited amount of active risk to managers where it is expected to be most productive in generating alphaCorrect
  2. BIt guarantees that each manager will outperform the benchmark by an amount equal to its allocated tracking error
  3. CIt eliminates the need to monitor managers because risk limits are fixed in advance
  4. DIt ensures that the sponsor's total portfolio VaR equals the sum of each manager's stand-alone VaR

Explanation

Risk budgeting treats active risk as a scarce resource and distributes it to managers or strategies with the best expected return per unit of risk. It does not guarantee outperformance, replace monitoring, or imply that VaRs add linearly, since diversification lowers total risk.

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