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Tactical Asset Allocation through Risk Budgeting

Private Wealth Management. Tactical Asset Allocation through Risk Budgeting . November 2007. Source: Morgan Stanley. Private Wealth Management. Investment tools. Risk budgeting. Expected returns = information ratio x active risk Net α = information ratio x active risk – fees

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Tactical Asset Allocation through Risk Budgeting

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  1. Private Wealth Management Tactical Asset Allocation through Risk Budgeting November 2007

  2. Source: Morgan Stanley Private Wealth Management Investment tools Risk budgeting • Expected returns • = • information ratio • x • active risk • Net α • = • information ratio • x • active risk • – • fees • Active risk matters! Risky business Why many fund managers underperform • In order to meet objectives for return on investment and outperform passive investment funds, it is essential to understand and manage risk across portfolios. • Our answer is to use a risk budgeting process, which addresses these issues: • What are your expected returns after fees? • What is the appropriate level of risk to meet your expectations? • Where is the risk? • How can we scale our allocations to various investments within the portfolio to match our conviction to the ideas? • How can we differentiate active risk from market risk? • How risk budgeting helps • Risk budgeting provides a quantitative breakdown of where risk exists in portfolios. We can use it to: • Set an overall level of risk accurately to achieve performance objectives by adjusting the allocation to various asset classes. • Determine the level or risk in individual investments and use the information to adjust allocations to ideas in which we have the most conviction. • Tracking error across the fund management industry has fallen over the past few years (see chart). Many fund managers: • Do not appreciate this fall in market volatility. • Do not realise how the various parts of their portfolios contribute to overall performance because they are unable to quantify risk accurately. • Do not take enough risk or they assign risk inappropriately. As a result, they do not meet targeted returns and continuously underperform benchmarks. • Do not take enough risk to enable returns to be sufficiently greater than their active management fees. Investors could achieve the same or higher returns through passive investment vehicles. • 12-month rolling tracking error against MSCI World Index • Source: Lipper. US dollar-denominated Global Equity Sicavs with record of six years or more. This information is for illustrative purposes only. Past performance is no guide to future performance and the value of investments and income from them can fall as well as rise. 11

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