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

A sponsor uses a total risk budget with these managers: A has an expected active return of 2% and tracking error of 4%; B has 3% and 4%. Active returns are uncorrelated, and the sponsor wants to maximize the information ratio of the combined active portfolio with weights summing to 100% of assets. Based on optimal allocation of risk budgets proportional to IR/TE logic (weights proportional to alpha/variance), what weight goes to Manager B?

Manager B should receive 60%. With uncorrelated active returns, information-ratio-maximizing weights are proportional to alpha divided by variance: 0.125 for A and 0.1875 for B. B's share is 0.1875 divided by 0.3125, which equals 60%.

  1. A40%
  2. B50%
  3. C60%Correct
  4. D75%

Explanation

Optimal weights are proportional to alpha/variance. A: 2/16 = 0.125; B: 3/16 = 0.1875. Sum = 0.3125. B weight = 0.1875/0.3125 = 0.60.

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