What Is Active Risk?

Investing involves various forms of risk, generally referring to the potential for an investment’s actual return to differ from its expected return. Investment professionals manage these risks by comparing a portfolio’s performance against a chosen market benchmark. This article explains active risk, a specific type of risk associated with investment strategies that aim to outperform such benchmarks.

Understanding Active Risk

Active risk quantifies the volatility of a portfolio’s returns relative to its benchmark. It measures the risk an investment manager undertakes by intentionally deviating from a chosen market index or benchmark to generate superior returns. Active management seeks to outperform a specific benchmark, which is a standard against which investment performance can be measured. Common benchmarks include the S&P 500 for large-cap U.S. stocks or the Bloomberg U.S. Aggregate Bond Index for investment-grade bonds.

The primary objective of active management is to generate “alpha,” representing the excess return of a portfolio compared to its benchmark. To achieve this, managers make investment decisions that differ from the benchmark’s composition, such as overweighting or underweighting certain sectors or individual stocks. These intentional deviations are the source of active risk. In contrast, passive investing aims to replicate benchmark performance, typically by holding its constituent securities, thus minimizing active risk.

Active risk differs from total risk. Total risk refers to the overall variability of a portfolio’s returns, often measured by the standard deviation of its absolute returns. This encompasses both market-wide movements and the specific risks taken by the manager. Active risk, however, isolates the risk stemming solely from the manager’s deviations from the benchmark.

A portfolio with high active risk means the manager has taken significant positions that differ from the benchmark, potentially leading to returns that vary widely. Conversely, a portfolio with low active risk indicates that the manager’s holdings closely mirror the benchmark, and its returns will likely track the benchmark more closely.

Calculating Active Risk

Active risk is primarily measured through “tracking error.” Tracking error quantifies the standard deviation of the difference between a portfolio’s returns and its benchmark’s returns over a specified period. This difference, often called “active return,” reflects the excess return achieved by the investment manager. A higher tracking error indicates greater divergence in performance.

To calculate tracking error, determine the active return for each period (e.g., daily, weekly, or monthly) by subtracting the benchmark’s return from the portfolio’s return. For example, if a portfolio returned 1.2% and its benchmark returned 1.0% in a given month, the active return would be 0.2%.

Once a series of active returns is obtained, their standard deviation is calculated. Standard deviation measures the dispersion or variability of active returns around their average. A low standard deviation suggests active returns consistently stay close to their average, while a high standard deviation indicates significant fluctuation. This calculation involves statistical methods to quantify the spread of returns.

Tracking error is commonly annualized for consistent comparison, regardless of the underlying data frequency. Annualization typically involves scaling the calculated tracking error to an annual basis, such as multiplying monthly data by the square root of 12.

Interpreting Active Risk

Different levels of active risk, measured by tracking error, provide insights into an investment manager’s strategy and potential outcomes. A higher active risk implies the portfolio’s returns are likely to deviate significantly from the benchmark, either positively or negatively. This can lead to periods of substantial outperformance or underperformance. For example, a manager with a 5% tracking error takes more active bets than one with 2%.

Conversely, a lower active risk suggests the portfolio’s performance will closely mirror its benchmark. This approach aims for consistent, benchmark-like returns, with less potential for large deviations. A low tracking error indicates a manager makes few active bets or that their active bets are relatively small and diversified, causing little deviation.

It is important to understand that active risk is a measure of the variability of active returns, not necessarily the direction of those returns. A high tracking error does not guarantee positive outperformance; it indicates a greater willingness to diverge from the benchmark. Therefore, active risk must be considered in conjunction with active return, or alpha. An effective active manager ideally generates positive alpha with a reasonable level of active risk, demonstrating that their deviations from the benchmark are leading to superior results.

Investors use active risk to assess whether an investment manager’s risk-taking aligns with their personal investment goals and risk tolerance. An investor comfortable with higher variability in returns might prefer a manager with higher active risk, hoping for greater outperformance. Conversely, an investor seeking returns closer to the benchmark with less volatility would opt for a manager with lower active risk. This metric helps investors evaluate if the potential for higher rewards from active management is justified by the associated level of divergence from the market.