You can hardly pick up a financial publication these days without being bombarded with news about portfolio risk management. Since the market downturn of 2007-2008, and despite the 5-year bull market that has followed, risk is front-and center in the minds of institutional asset managers and owners alike.
But how does one quantify risk? In this post, we demystify three go-to active risk measures—one old, one new and one that (sometimes) gets lost in the shuffle: tracking error, maximum drawdown and overconcentration/specific risk.
Tracking error: How active is your portfolio?
What it is
Tracking error is one of the oldest and most commonly used portfolio risk metrics. Also known as the standard deviation of active, or excess, returns, it measures how a manager performs relative to the benchmark. It is derived using the difference between the manager’s return and the benchmark return for each measurement period (e.g., monthly), and then calculating the standard deviation of the difference. It is expressed as a percentage range—the lower the tracking error, the more index-like the portfolio; the higher the tracking error, the more active the portfolio is.
Note that, at least theoretically, if an active manager has a high active return, but it is constant in each measurement period, the tracking error could near zero. In practice, however, keeping a constant active return over each period is nearly impossible.
While there is no standard or target range, some “typical” values would be:
|Type of portfolio||Typical tracking error|
|Theoretical index fund||+/- 0.0%|
|Enhanced index fund||+/- 1.5-2.0%|
|Traditional active fund||+/- 4.0-7.0%|
|Aggressive fund||+/- 10.0-15.0%|
|Unconstrained fund||> 15.0%|
What it is used for
What makes tracking error so useful is that it is one of the few risk measures that looks at performance relative to a benchmark. In doing so, it contributes important insights into two areas: how active a manager is and how consistently they over- or underperform.
Tracking error provides proof of how much active risk a manager is willing to take and, when used in tandem with statistics like active share, is a powerful tool for managers who want to distinguish themselves from closet indexers.
What it is
Maximum drawdown, also known as MDD, is a relative newcomer to the institutional investor’s risk measurement toolkit. It measures the maximum peak-to-trough loss of an investment—the absolute worst-case experience in the portfolio’s history. MDD lets the investor see how much they would have lost if they bought in at the highest historical level, rode the investment all the way to the historical low, and then sold it. OUCH.
MDD is expressed as the percentage of value lost, so low numbers are better than high ones. The maximum loss would, of course, be 100%.
What it is used for
MDD gives investors two pieces of information about a portfolio: The historical worst-case scenario and the capital-preservation potential of the underlying strategy. Both are important decision-making tools for potential investors. Comparing the MDD of a manager’s portfolio to the MDD of the benchmark for the same period can provide insight into how successful the manager is in controlling market risk in their strategy.
In addition to the MDD itself, the period of time taken to recover from the MDD provides insight into how quickly the manager is able to rebound after a severe downturn.
Finally, some investment managers are using MDD to help them create portfolios by incorporating MDD limits into their optimization routines as a way to constrain future losses.
Overconcentration: Too much of a good thing
What it is
One of the cardinal rules of prudent investing—and a requirement for asset fiduciaries—is diversification. The idea is that portfolio volatility and risk can be reduced by investing in a variety of securities with different characteristics. Overconcentration is the opposite of diversification—putting too many eggs in one basket.
What it’s used for
Evaluating portfolio concentration vs. the benchmark has several uses. Asset managers can show how their portfolios are well-diversified and provide evidence that their holdings are not concentrated in a few stocks. In addition, asset owners frequently have strict investment guidelines for the percentage of the portfolio that can be invested in any one stock or sector. By evaluating portfolio holdings against the benchmark, fiduciaries can quickly see whether their guidelines are being followed.
This type of analysis can help investment managers demonstrate how and where they are taking on specific risk versus the benchmark, and provide a basis for discussion when meeting with asset owners and clients—especially when the merits of active management are questioned.
Active risk measurement need not be complex, and there are a variety of useful tools that asset owners and managers can use to help them manage and understand the risk profile of their portfolios. If you would like to see some real-life examples of how managers are using these risk measures to demonstrate their active contribution to returns, click here.