How do I build an active risk budget at the fund level?

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AcadiFi · Accepted Answer

Active risk budgeting allocates a total tracking error target across strategies, controlling both total active risk and contribution per sleeve. Start with the fund-level target: say Wintermere Institutional Fund has 250 bps TE budget against a 60/40 blended benchmark. Next assess each sleeve's active risk (standalone TE) and active correlation. Contribution to total TE requires the covariance of active returns, not just standalone TE sum. For 8 sleeves with standalone TEs ranging 80-400 bps and mostly low cross-correlation (0.1-0.3), diversification benefits apply: total fund TE might be 220 bps versus a weighted-sum of 340 bps. Optimize sleeve weights to maximize expected information ratio subject to total TE <= 250 bps using quadratic programming on the active covariance matrix. Monitoring: marginal contribution to TE (MCTE) tells you which sleeves drive active risk. A concentrated sleeve with TE of 400 bps at 15% weight might contribute 40% of total risk despite 15% capital - signaling imbalance. Rebalance by trimming concentrated sleeves or hedging their beta. Present to the investment committee quarterly with contribution charts and hypothetical reallocation scenarios. ```mermaid graph TD A[Fund TE
250 bps] --> B[Sleeve 1] A --> C[Sleeve 2] A --> D[Sleeve N] B --> E[MCTE
analysis] C --> E D --> E ```

How do I build an active risk budget at the fund level?

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