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

A sponsor allocates a total risk budget across two managers. Manager X has an information ratio of 0.60 and Manager Y has 0.30. Assuming returns are uncorrelated and the sponsor can choose active risk freely, which allocation principle best maximizes the combined portfolio information ratio?

Active risk should be allocated in proportion to each manager's information ratio. With uncorrelated active returns, the optimal risk budget rises with IR, so Manager X, at 0.60, gets twice the active risk of Manager Y at 0.30. Equal or inverse splits give less return per unit of risk.

  1. AAllocate active risk in proportion to each manager's information ratioCorrect
  2. BAllocate active risk equally to both managers
  3. CAllocate all active risk to Manager Y to diversify
  4. DAllocate active risk in inverse proportion to information ratios

Explanation

With uncorrelated active returns, the optimal active risk weight is proportional to IR divided by the sponsor's risk aversion, so risk is allocated in proportion to IR. X gets twice Y's active risk. Equal or inverse allocation wastes risk budget on lower-skill managers.

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