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

A sponsor has a total active risk budget with two managers. Manager 1 has expected alpha 1.5% and tracking error 3.0% (information ratio 0.5). Manager 2 has expected alpha 2.0% and tracking error 8.0% (information ratio 0.25). Assuming uncorrelated active returns, which action is most consistent with efficient risk budgeting?

Shift risk budget toward Manager 1. It earns 0.5 of alpha per unit of tracking error against 0.25 for Manager 2, and with uncorrelated active returns efficient budgeting equalises marginal alpha per unit of marginal risk. Absolute alpha alone ignores the risk consumed.

  1. AShift risk budget from Manager 2 toward Manager 1, since it has the higher information ratio, until marginal alpha per unit of marginal risk is equalisedCorrect
  2. BAllocate the budget equally by tracking error because they both add alpha
  3. CAllocate all the budget to Manager 2 because its alpha is higher
  4. DReduce both budgets because information ratios are below 1

Explanation

Efficient risk budgeting equates alpha per unit of marginal risk across managers; with uncorrelated active returns that ratio is the information ratio scaled by risk allocation. Manager 1's IR of 0.5 beats Manager 2's 0.25, so risk should be tilted toward Manager 1, subject to capacity limits. Absolute alpha ignores the risk used, and the IR threshold of 1 is not a rule.

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