Structural positions and risk budgeting : quantifying the impact of structural positions and deriving implications for active portfolio management

  • Structural positions are very common in investment practice. A structural position is defined as a permanent overweighting of a riskier asset class relative to a prespecified benchmark portfolio. The most prominent example for a structural position is the equity bias in a balanced fund that arises by consistently overweighting equities in tactical asset allocation. Another example is the permanent allocation of credit in a fixed income portfolio with a government benchmark. The analysis provided in this article shows that whenever possible, structural positions should be avoided. Graphical illustrations based on Pythagorean theorem are used to make a connection between the active risk/return and the total risk/return framework. Structural positions alter the risk profile of the portfolio substantially, and the appeal of active management – to provide active returns uncorrelated to benchmark returns and hence to shift the efficient frontier outwards – gets lost. The article demonstrates that the commonly used alpha – tracking error criterion is not sufficient for active management. In addition, structural positions complicate measuring managers’ skill. The paper also develops normative implications for active portfolio management. Tactical asset allocation should be based on the comparison of expected excess returns of an asset class to the equilibrium risk premium of the same asset class and not to expected excess returns of other asset classes. For the cases, where structural positions cannot be avoided, a risk budgeting approach is introduced and applied to determine the optimal position size. Finally, investors are advised not to base performance evaluation only on simple manager rankings because this encourages managers to take structural positions and does not reward efforts to produce alpha. The same holds true for comparing managers’ information ratios. Information ratios, in investment practice defined as the ratio of active return to active risk, do not uncover structural positions.

Download full text files

Export metadata

Additional Services

Share in Twitter Search Google Scholar
Author:Ulf HeroldGND
Series (Serial Number):Working paper series / Johann-Wolfgang-Goethe-Universität Frankfurt am Main, Fachbereich Wirtschaftswissenschaften : Finance & Accounting (074)
Publisher:Univ., Fachbereich Wirtschaftswiss.
Place of publication:Frankfurt am Main
Document Type:Report
Year of Completion:2005
Year of first Publication:2001
Publishing Institution:Universitätsbibliothek Johann Christian Senckenberg
Release Date:2005/10/11
Tag:Pythagorean theorem; active management; information ratios; risk budgeting; structural positions; tactical asset allocation
Source:Working paper series / Johann-Wolfgang-Goethe-Universität Frankfurt am Main, Fachbereich Wirtschaftswissenschaften : Finance & Accounting ; 74
Institutes:Wirtschaftswissenschaften / Wirtschaftswissenschaften
Dewey Decimal Classification:3 Sozialwissenschaften / 33 Wirtschaft / 330 Wirtschaft
Licence (German):License LogoDeutsches Urheberrecht