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

A sponsor finds that its equity managers' active positions are all tilted toward small-cap value, so that a single factor drives most of the active risk. What is the most appropriate risk-budgeting response?

The sponsor should aggregate positions at the total plan level, identify the common small-cap value concentration, and adjust budgets or the manager mix. Individual tracking-error limits can all be met while the plan holds a concentrated, undiversified factor bet.

  1. ARely on each manager's tracking-error limit, since limits are respected individually
  2. BIncrease every manager's budget to improve diversification
  3. CAggregate positions at the total plan level, identify the concentration, and adjust budgets or manager mixCorrect
  4. DReplace tracking-error limits with a stop-loss rule for each manager

Explanation

Individual limits can all be respected while hidden factor concentration builds in aggregate. The sponsor must look through to total-plan exposures and adjust budgets or add managers with different exposures. Raising budgets would worsen concentration.

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