Active Risk
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Active Risk refers to that segment of risk in an investment portfolio that is due to active management decisions made by the portfolio manager. It does not include any risk (return) that is merely a function of the market’s movement. In addition to risk (return) from specific stock selection or industry and factor ‘bets’, it can also include risk (return) from market timing decisions. A portfolio’s active risk, then, is defined as the annualized standard deviation of the monthly difference between portfolio return and benchmark return. Thus, an active risk of x per cent would mean that approximately 2/3rd of the portfolio’s returns (one standard deviation from mean) can be expected to fall between +x and -x per cent of the mean excess return. It may be calculated as a realised, or ex post number (derived from the actual returns of a varying portfolio) or as a forward, ex ante, or predicted, number (usually based on a multifactor model defining the co-variance relationships between each pair of securities in the current portfolio). Active risk is normally called tracking error in Europe. It should be noted that there is no necessary or stable relationship between ex ante and ex post tracking error. Furthermore, while tracking error measures the standard deviation of active returns, it does not measure any systematic trend in those returns.
