Risk Budgeting and Portable Alphas

Risk Budgeting
and Portable Alpha

The Journal of Investing 2002.11.2:15-22. Downloaded from www.iijournals.com by Guido Chagas on 01/02/15.
It is illegal to make unauthorized copies of this article, forward to an unauthorized user or to post electronically without Publisher permission.
ROBERT D. ARNOTT
ROBERT D. ARNOTT
is a managing partner and
chief executive officer of
First Quadrant, L.P., in
Pasadena, CA.
rarnott@firstquadrant.com
wo of the most important developments in institutional investing

in the past decade are the increasing focus on risk budgeting and
increasing pursuit of portable alpha. The two
can be pursued independently, but they are
interconnected and best seen as two aspects of
the same puzzle. They are tied together by the
simple fact that asset allocation and the quest
for alpha are separable.
THE CLASSIC MODEL

FOR RISK MANAGEMENT
The classic approach to fund management places the asset allocation decision first
and foremost, and then deals with the quest for
alpha. This involves deciding how much to
allocate to domestic stocks, to bonds, to international, to emerging markets, and to alternative strategies, such as real estate, venture
capital, hedge funds, commodities, and whatever else may be deemed worthy of a role in
the portfolio.
Once that macro asset allocation decision is made, the next decision is the active
asset allocation decision. Do we want to allow
the mix to differ from our intended policy
mix? If so, how much drift is tolerable? How
(and how often) do we rebalance to the policy mix? Do we permit deliberate tactical
departures from our policy mix? If so, by how
much, and based on what disciplines or strategies? Do we apply defensive option or option
SUMMER 2002
replication strategies (e.g., collar strategies or

portfolio insurance), which directly or indirectly alter our asset allocation?1
Once the various nuances of asset allocation have been dealt with, the next question is the split between active and passive.
How much should be allocated to the quest for
alpha? For instance, if 60% is allocated to
domestic stocks, then do we want 10% or 20%,
or 40% invested with active managers, correspondingly leaving 50%, 40%, or 20% in passive index replication? This decision often
reflects the tolerance the investment committee of the board might have for shortfalls, when
and if they occur.
Once we decide how much to commit
to active management, we need to decide
which managers to employ in each asset category. We want the best domestic stock and
bond managers, the best international managers, the best managers for the cash reserves
in the portfolio, and so forth.
This should be based on the expected
alphas and correlations of the managers, but
the easy path to judging the expected alphas
and correlations is to look at the past. What
managers have a sensible, well-reasoned, investment process, backed up by strong recent
results?
PORTABLE ALPHALEVEL ONE
One of the first things we notice in this

process is that theres too much room for slipTHE JOURNAL OF INVESTING
15
page. Cash reserves build up in the equity and bond portfolios, and sit idle waiting for allocation to a manager or
for distribution to meet the obligations of the fund. The
drain on performance is startlingly large.2
Then, the allocations to the asset classes drift with
the whims of the capital markets, unless a conscious, disciplined rebalancing program is put in place. The allocations to the managers change with 1) the relative
performance of their asset class, 2) the relative performance of their style, and 3) the relative alpha of the managers. To which we then add the cost of manager
terminations and hirings, which is considerable (that cost
has variously been put at 1% to 4% of the assets moved
from one manager to another, depending on asset class and
manager style).
The second thing that we notice in this process is
that the quest for alpha is held hostage to our asset allocation. Suppose we find the following strategies:
International managers who are expected to do as

well as domestic managers, but their alpha is offset
by the withholding taxes, which take the net alpha
to about zero.
In our policy asset mix, we have 60% in domestic
stocks and 20% in domestic bonds, so we can get the
alphas from these managers. But, we have zero allocated
to T-bills, where the hedge fund manager might be viewed
as an interesting absolute returns manager. We have difficulty dealing with the junk bond manager, because of
her exposure to both stock and bond market behavior
(which pool of assets do we invest with her, anyway?).
And, we have zero allocated to international bonds, so
we cannot invest anything with the bond-plus-currency
manager without violating our asset mix policy.
We are left with 100 bp from our stock managers
and 50 bp from our bond manager (if our selections pan
out as expected), less various bits of slippage in the portfolio. If we wind up 70 bp ahead of passive results, its a
success.3
Exhibit 1 shows how this works at the fund level.
We cannot invest anything with the more interesting managers, who have some reasonable possibility of
adding materially to our returns, because we are having
trouble finding reliable all-season, high-alpha, high-information ratio managers within the conventional stocks and
bonds. Or can we?4
Suppose we take the hedge fund manager, and buy
stock index futures with notional value matching that of
the hedge fund allocation. Because stock index futures
produce returns that closely match the difference between
A hedge fund manager, with an interesting leveraged

arbitrage strategy, who we think can reliably deliver
15% returns, roughly equivalent to a T-bill return
plus a 1,000 basis point alpha.
An international bond-plus-currency manager who
can add 200 basis points to the global bond index
results.
A junk bond manager who we think can add about
400 basis points to the bond indexes, albeit with a
0.20 beta with the stock market.
Domestic stock and bond managers who we think
can add 100 basis points and 50 basis points to their
respective index results.
EXHIBIT 1
Alpha ManagementClassic Model
Risk Attributes
Stock
Beta
Hedge Fund Manager
International Bond + Currency Strategy
High-Yield Bond Manager
60% Domestic Stock Managers
20% Domestic Bond Managers
20% International Stock Managers
Combined Fund Result
Bond
Beta
Hedged
EAFE
F/X
Beta
Beta
Intl
Bond
Beta
Hedged
Expected
Alpha/IR
No fit in fund; policy allocation to cash is zero.

No fit in fund; policy allocation to international bonds is zero.
No fit in fund; policy allocation to hybrid assets is zero.
~1.0
~0.0
~0.0
~0.0
~0.0
1.00% / 0.25
~0.0
~1.0
~0.0
~0.0
~0.0
0.50% / 0.25
~0.0
~0.0
~1.0
~1.0
~0.0
0.00% / 0.00
~0.6
~0.2
~0.2
~0.2
~0.0
0.70% / 0.29*
*Assuming the alphas are uncorrelated.
16
RISK BUDGETING AND PORTABLE ALPHA
SUMMER 2002
EXHIBIT 2
Portable AlphaLevel One: Examples of Porting Alpha
Risk Attributes
Stock
Beta
Bond
Beta
Hedged
EAFE
Beta
F/X
Beta
Intl
Bond
Beta
Hedged
Expected
Alpha/IR
20% Hedge Fund Manager

Plus S&P Futures
Net Result
~0.0
1.0
~1.0
~0.0
~0.0
~0.0
~0.0
10% / 0.5
~0.0
~0.0
~0.0
~0.0
10% / 0.5
20% Intl Bond + Currency

Minus Intl Bond Futures
Minus Passive Currency Hedge
Plus T-Bond Futures
Net Result
~0.0
~0.0
~0.0
~0.5
~1.0
-1.0
2% / 0.5
~0.0
1.0
~1.0
~0.0
~0.0
~0.0
2% / 0.5
~0.6
~0.0
~0.0
~0.0
4% / 0.5
+1.0
~1.0
+1.0
~1.0
~0.0
4% / 0.5
20% High-Yield Bond Manager

~0.2
Minus Stock Futures
-0.2
Minus T-Bond Futures
Plus EAFE-Tracking Futures/Forwards
Net Result
~0.0
-0.6
~0.0
-0.5

0% Intl Stock Managers
~1.0
~0.0
~0.0
~0.0
~0.0
1% / 0.25
Not required. Covered by Intl Bond + Currency Mgr.
Not required. Covered by ported Junk Bond Mgr.
~0.6
~0.2
~0.2
~0.2
~0.0
3.6% / 0.8*
the stock index total return and the total return on Tbills, now we have S&P plus 1,000 basis points. We can
now fund this manager out of our equity allocation.5
Suppose we take the international bond-plus-currency manager, short international bond futures, and short
currency forwards or futures in an amount that reflects the
managers normal currency exposure. Now we have converted the manager to a cash-plus-alpha manager. Suppose
we buy Treasury bond futures. Now we have converted that
manager one step further to a T-bond-plus-200 bp manager. We can fund this manager out of our bond allocation.
Suppose we take the high-yield bond manager, and
short stock and bond futures in an amount that reflects
the average stock beta and bond duration of that manager.
Now we have converted the manager to a cash-plus-400
bp manager. Suppose we now buy a basket of international
stock and currency futures that closely replicates the MSCI
EAFE index. Now we have converted the manager yet
another step to an international stocks-plus-alpha manager. We can fund this manager out of the international
stocks portion of our fund, even though the manager has
neither international holdings nor equity holdings.
The essence of the highly successful PIMCO Stocks
Plus strategy is that the cash markets offer a steep yield
curve and large quality spreads. By buying cash instruments
SUMMER 2002
that are a bit longer in maturity and using a careful blend

of corporate and other non-Treasury instruments, one can
pick up an extra 50 basis points of cash yield. Buying stock
index futures delivers a reasonably reliable 50 bp over and
above the S&P return. Its a simple, yet powerful, concept.
Find the managers and strategies that offer the most
reliable prospective alphas...and port these alphas over to
the asset allocation that you want. But, were still trapped
in the prison created by our asset allocation.
PORTABLE ALPHALEVEL TWO
What about a more ambitious decoupling of asset

allocation and alpha? Lets find the managers and strategies that offer the most reliable prospective alphas (as best
we can gauge the future). Pay no attention to which category we want to use to fund the manager.
If we have a manager who has an interesting strategy, which we expect will deliver a reliable alpha, then
lets hire him. How much should we invest with him? As
much as we think is appropriate and prudent.
If we have another investor with a complementary
strategy, using totally different instruments, lets hire her
too. How much to invest? Again, as much as we think is
appropriate and prudent.
THE JOURNAL OF INVESTING
17
Now, we have a basket of managers and strategies,

all of which are interesting, all of which we hope can add
good value for us, and none of which is selected based on
the asset class within which the managers work.
What do we do about this tangled mess of risks and
asset classes? Simple. Port it over to the asset allocation that
we want. Suppose, instead of hiring the stock and bond
managers, we hire the managers who we think can collectively add reliable value. Now we have a mix of market exposures that may bear little resemblance to our
intended asset allocation.
But, if we take the simple difference between the
asset mix exposures we have and the exposures we want,
we have a simple recipe for the futures we need. Putting these
futures in place gives us exactly the asset allocation that we
want, plus the roster of alpha sources (managers and strategies) that we think offer us the best prospects for the future.
In Exhibit 3, we illustrate this, with an unusually
aggressive allocation to the best managers, those with
an expected IR of 0.5 and large expected alphas that are
deemed likely to be unusually reliable. These allocations
are made without any reference to the policy asset allocation. We
then simply sum the anticipated structural risks of these
managers, and put in place whatever futures are needed
to bring the effective asset mix back in line with the policy targets.
PITFALLS OF PORTING
This process is actually simpler to manage, once its

in place, than the classic structure. Why? Because the classic structure requires constant tweaking of the asset mix;
for rebalancing and tactical purposes, of the manager mix,
to prevent unintended style bets from creeping into the
fund; and of the placement of cash flows, both into and
out of the fund. With a portable alpha structure:
Cash flows into the fund are placed with the manager or strategy that is deemed most likely to boost
the risk-adjusted performance of the fund.
Cash flows out of the fund are taken from the manager or strategy in which confidence is waning, the
strategy deemed least likely to help the risk-adjusted
performance of the fund.
Allocations to managers are based on perceived likely
risk-adjusted performance, not their asset class.
Estimated risk exposures of the fund, based on the
risk exposures of the managers, are updated very
easily (an Excel spreadsheet, with one line for each
manager, weighted by the allocation to that manager can easily do the trick).
Futures positions for porting can be recalculated and
readjusted as often as one updates the risk exposures
of the fund.
EXHIBIT 3
Portable AlphaLevel Two: Fund-Level Alpha Porting
Risk Attributes
Stock
Beta
Bond
Beta
Hedged
EAFE
Beta
F/X
Beta
Intl
Bond
Beta
Hedged
Expected
Alpha/IR

20% High-Yield Bond Manager
0% Intl Stock Managers
~0.0
~0.0
~0.0
~0.0
~0.0
10% / 0.5
~0.0
~0.0
~0.0
~0.5
~1.0
2% / 0.5
~0.2
~0.6
~0.0
~0.0
~0.0
4% / 0.5
~1.0
~0.0
~0.0
~0.0
~0.0
1% / 0.25
~0.0
~1.0
~0.0
~0.0
~0.0
0.5% / 0.25
Not required. Covered by ported strategies.
Combined Result Pre-Porting

Target Combined Result
Net Porting Required
~0.44
~0.6
+0.16
Porting Transactions
Plus S&P Futures
Plus T-Bond Futures
~0.12
~0.2
+0.08
~0.0
~0.2
+0.2
~0.1
~0.2
+0.1
+0.16
+0.08
~0.6
~0.2
~0.2
~0.0
-0.2
3.6% / 0.8*
-0.2
+0.2
+0.1
~0.2
~0.2
~0.0
3.6% / 0.8*
18
SUMMER 2002
Rebalancing to the intended policy mix becomes

almost automatic. No committee approvals process is
necessary. There is no need to debate the relative
merits of the rebalancing trades, no weighing how best
to lighten one asset class in favor of another (which
manager, among those we really like and want to
retain, do we cut because we need to rebalance).
Porting is not without its costs and complications.
The most obvious problem is the requirement to fundamentally rethink and restructure the way that fund management is carried out. Classes of managers and sources
of alpha that would have been considered out of bounds
are now very easily considered as candidates for the
portable alpha fund.
This fundamental difference from the classic structure carries with it the mirror-image problem: If a move
to a portable alpha framework is relatively easy, but requires
a fundamentally different mind-set and structure for asset
management, then a move back to the classic structure
requires an equally fundamental change in the mind-set
and structure for asset management.
In other words, as sensible and powerful as the
portable alpha model for institutional asset management
may be, all levels of management should buy into the
concept before it is pursued, since a reversal on something as fundamental as the basic framework for asset management will be very disruptive.
There is also a need to manage and roll the futures
positions relating to the porting process. The gross futures
positions in Exhibit 3 total 74% of fund assets. This sounds
large, but its really not: Despite an underlying portfolio
that is wildly different from the target policy mix, with
an equally wildly unconventional set of managers, this is
only the amount of futures exposure required to shift the
effective mix of the fund to match the policy targets.
But, suppose futures rolling costs are 10-20 basis
points per year (the typical estimated range, although
objective evidence is actually more encouraging than this);
this means that we forfeit 7-15 bp per year of our alpha
in order to port that alpha into the target asset mix.
Our own trading experience would suggest that this
popularly accepted trading cost is too high by at least a
factor of two, but these are the consensus numbers that
are often cited.
If a portable alpha structure costs us, lets say, 5-20
basis points in rolling costs, this is not a burdensome cost
against an alpha of 360 bp (as it is in Exhibit 3). And, that
lofty alpha would have been impossible, indeed unimagSUMMER 2002
inable, without portable alpha as the basic structure. But,

it is a cost that begins to matter if the actual result is closer
to neutral, if our expected alphas fail to materialize. And,
it is a cost that matters a great deal if our pre-porting alpha
is negative.
In other words, manager selection matters a great
deal in a portable alpha framework, just as it does in the
classic framework. Indeed, it matters more than in the classic framework, by an amount that reflects these rolling
costs. That said, the opportunity for meaningful alpha is
likely to be much greater with a portable alpha framework
than it is with the classic structure, because of the panoply
of potential alpha sources that are newly at our disposal.
RISK BUDGETING
Risk budgeting is an increasingly popular concept

in institutional asset management. Its roots go straight to
Markowitzs seminal 1952 work on optimization and the
diversification of risk. How much risk are we prepared to
bear, in aggregate, at the fund level?
In effect, risk budgeting is the disciplined apportioning of risk among the active decisions that we may
make: the asset allocation decisions (both policy and tactical), the manager selection and weighting decisions, the
stock selection and bond selection decisions, and so forth.
Risk budgeting is easy enough to do in the context
of the classic structure. Most clients and managers mutually agree on a tracking error for the strategies. This is
balanced against the tracking error targets of other managers. If the managers are sufficiently complementary
(uncorrelated), then the alphas are additive, but the risks
mount far slower than the alphas. This is intended to minimize the clients risk of adverse shocks.6
If the selected managers are uncorrelated, then even
if we deliver two-sigma disappointment, the overall fund
is probably fine. Yet risk budgeting at the portfolio level
is limited, if we are constrained by the classic model for
portfolio allocation.
Exhibit 4 shows a simplified result of risk budgeting. If we use an optimizer to maximize the information
ratio of a portfolio, and if those strategies are completely uncorrelated, then the asset mix is proportional to alpha, divided
by the variance of alpha (tracking error squared).
The point of this exercise is not the mathematics of
optimization, but rather the much simpler point that an
optimizer can then be used to maximize the IR of a fund.
This can realistically be done only in the context of
portable alpha, however. In the classic structure, we are
19
EXHIBIT 4
Portable AlphaLevel Three: Fund-Level Alpha Porting, with a 2% Risk Budget
Risk Attributes
Stock
Beta
Bond
Beta
Hedged
EAFE
Beta
F/X
Beta
Intl
Bond
Beta
Hedged
Expected
Alpha/IR

~0.0
~0.0
~0.0
~0.0
~0.0
10% / 0.5
~0.0
~0.0
~0.0
~0.5
~1.0
2% / 0.5
12.5% Junk Bond Manager
~0.2
~0.6
~0.0
~0.0
~0.0
4% / 0.5
12.5% Domestic Stock Managers
~1.0
~0.0
~0.0
~0.0
~0.0
0.5% / 0.25
~0.0
~1.0
~0.0
~0.0
~0.0
0.5 % / 0.25
20% Passive Intl Stock*
~0.0
~0.0
~1.0
~1.0
~0.0
0% / 0.00
* Can be used, since ported strategies use only 80% of fund assets. This avoids some of the international
futures roll costs, which are higher than domestic costs.
Combined Result Pre-Porting
Target Combined Result
Net Porting Required
Porting Transactions
Plus S&P Futures
Plus T-Bond Futures
~0.15
~0.6
+0.45
~0.325
~0.2
-0.125
~0.2
~0.2
+0.0
~0.325
~0.2
-0.125
+0.45
~0.2
1.75% / 0.94*
-0.25
-0.125
~0.6
~0.25
~0.0
-0.25
-0.125
~0.2
~0.2
~0.0
2.1% / 0.93*
*Assuming the alphas are uncorrelated. International manager tracking error assumed to be 4.0%.
in effect dealing with a severely constrained optimization

puzzle, and the opportunity to materially boost the IR is
quite limited. In a portable alpha context, those constraints vanish.
In this example, we have decided that the 3.6% alpha
of Exhibit 3 is wonderful, but that the 4.5% tracking error
at the fund level is too high. We want to have overall portfolio risk come in a notch under 2%. We optimize the mix
of alpha strategies, and find that we can maximize our
alpha, subject to a 1.9% tracking error, all the way up to
1.75% (Exhibit 4).
This is nearly twice as good as the alpha/risk ratio
of our best single strategy. And, its achieved precisely
because 1) we can select alpha sources without regard to
asset mix, and 2) we can optimize those risks to maximize
the IR, and hence the consistency of results that are delivered to the fund at large.
One of the inelegant elements of the classic model
is the active/passive allocation decision. Whether we place
10% of our fund with a manager who has 4% tracking
error or 20% of our fund with a manager who has 2%
tracking error, the contribution to overall fund risk is the
same. But the active/passive decision is typically made in
a fashion that suggests that both managers are equally
risky. This is patently false.
20
Interestingly, risk budgeting also provides an automated answer to the active/passive question. In effect,
with risk budgeting, the optimizer will maximize expected
alpha at the intended tracking error, and whatever remains
uninvested in active alpha strategies is the appropriate passive allocation. This can then be deployed into whichever
asset class is most underweighted relative to policy benchmarks, in order to minimize the scope of the futures positions required for the portable alpha, minimizing the
futures positions that need to be rolled at some modest
cost. In so doing, the indexed portion of the assets actually contributes to the overall fund alpha.
TRACKING ERROR AND CORRELATIONS:
AN IMPRECISE SCIENCE
Even if one does not choose to move to a portable

alpha structure, risk budgeting is part of the fund management process. If we dont manage the risk budgeting
decision consciously, our allocations among managers and
strategies will do it for us.
It makes sense to take this decision in hand, and to
use whatever tools we have at our disposal to make sensible decisions based on our best estimates of future returns
and portfolio risks.
SUMMER 2002
One of the pitfalls in managing a risk budgeting

process is that risk itself is an imprecise concept. This
holds true on both the tracking error side and on the correlations side. Long-Term Capital Management collapsed,
despite a targeted 15%-20% risk budget for the overall
portfolio. This happened for three simple reasons.
First, strategies that were assumed to be uncorrelated, because they had been uncorrelated in the
past, turned out to be positively correlated in a turbulent liquidity crisis. This meant that the normal
risk was not 15%-20%, but rather 20%-25%.
Second, LTCM overlooked the simple fact that the
capital markets have volatility that is not static. When
market volatility rises, so does alpha volatility, or
tracking error. As volatility within the markets doubled and tripled, volatility was now at 40%-75%.
Third, and lethally, LTCM overlooked the fact that
multi-sigma events happen in the capital markets;
indeed they are commonplace. A 60% annual tracking error means monthly volatility of nearly 20%.
Against a flawed expectation of 20% annual risk, this
is huge, but not lethal. But, what if we have a fivesigma event? With 20% monthly risk, a five-sigma
event is deadly. This was the LTCM experience, and
its fatal flaw.
In statistics, in normally distributed data, this never
happens. Volatility doesnt change; correlations might be
misestimated, but they dont change. And, five-sigma
events dont happen. In the capital markets, all three happen from time to time.
The growth/value divergence in small-cap stocks
from December 1999 to February 2000 was over 5,000
basis points. Thats a six-sigma event. The large-cap/smallcap divergence in 1998 was 4,000 basis points. This is a
four-sigma event, lasting an entire year. The market crash
in 1987 and the mini-crash in 1989 (21% and 8%, respectively, in a single day) were 20-sigma and 7-sigma shocks,
when measured against market volatility of the prior year.
Daily shocks of five- to ten-sigma are rare in any
single investment, but they happen somewhere in the world
often enough. Monthly shocks of four- to six-sigma are
rare, and annual shocks of three- to five-sigma are rare.
But, again, they happen somewhere in the world with
some regularity.
So, there are several problems with risk estimation,
and hence with risk budgeting, which should lead us to
budget risk more conservatively than we might in a norSUMMER 2002
mal (i.e., statistically, a normally distributed) world.

Estimated correlations are imprecise. If we have 60
months of data, the standard error in our estimate of correlations between strategies, alphas, or markets is roughly
0.13. This means that, if we think two strategies are uncorrelated, they may have 0.2 or +0.2 correlation, with about
a 5% chance of either. And, correlations change over time.
All of this means that one should probably assume that
the true correlation, looking to the future, is higher than
the correlation that we observe in the historical data.
Correlations in up and down markets are often different (as LTCM discovered to its and its clients chagrin).
One Wall Street adage suggests that the only thing that
rises in fast-falling markets is correlation. It is imperative
to look at both.
Volatility estimates are less imprecise. If we have 60
months of data, volatility has a standard error of less than
10.0%. Thats pretty good. Indeed, to the surprise of many
non-statisticians, its a good deal better than the uncertainty
on the correlation side. But, it does mean that if we are
targeting 2.0% tracking error, no one should ever be surprised if the actual outcome is 1.8% or 2.2%, even if market volatility is steady.
Volatility changes over time. If volatility drops in
half and then doubles, we may see our targeted tracking
error plunge to 1.0% or soar to 4.0%. The average tracking error over time, in this illustrated case, averages not
2.0% (or 1.8% or 2.2%), but actually leaps to 2.9%. This
is one reason that tracking error is rarely as low as its
intended to be.7 One should take the science of risk management seriously. Recognizing and modeling the changes
in volatility over time improves the management of a
tracking error budget. There may be alpha surprises on
the upside or downside from time to time, but no lasting
surprises on the tracking error in portfolios.
By implication, sponsors who ask for 2.0% tracking
error and are upset if it drifts to 2.2% or 2.5% or even
2.9% ought to aim for a lower tracking error, so that they
can comfortably tolerate the inevitable times when risk
comes in above target.
Market shocks can create multi-sigma events. The
overall fund should be managed to a tracking error so that
the investment committee overseeing the fund will not
overreact to even a three-sigma shock, because a threesigma shock will happen from time to time, with far more
regularity than we would find in any normal distribution.
In our small-cap programs, for instance, we were on
the wrong side of the 5,000 basis point, six-sigma,
growth/value shock from December 1999 to February
21
2000. Even with a modest bet, this led to a startling downdraft of around 8%. While the risks in a single program are,
ideally, diversified away by retaining uncorrelated managers,
it is imperative that the risk budget for the overall fund
allow for such events. This points to a more conservative
overall risk budget than we might think we can tolerate.
This is simply one example of the imprecise science
of managing risks.
CONCLUSION
The recognition that asset allocation and alpha are

separable and independent decisions is one of the most
important developments of the 1990s, far eclipsing the
importance of the proliferation of new instruments or
trading techniques for institutional portfolios. It enables
a sharp improvement in the opportunity for effective risk
budgeting in portfolios, yet another important innovation in institutional asset management in the 1990s. It
also brings with it a recognition of the opportunity for
portable alpha, the way to most effectively optimize risk
budgeting and maximize alpha.
ENDNOTES
1
Ive often been puzzled that funds will choose not to

consider deliberate departures from the policy mix but will
cheerfully countenance accidental departures from the policy
mix through asset mix drift. Both contribute the same tracking error relative to the policy mix, yet one seems to offer some
possibility of adding to returns, while the other seems sheer
folly, a conscious shirking of fiduciary responsibility.
Ive always felt that the two intellectually honest choices
are to 1) engage in a disciplined framework for active tactical
asset allocation, based on a well-reasoned process, or 2) engage
in a systematic process of rebalancing, if not through active
trading in futures, then at least through careful management of
the cash flows into or out of the fund. Most funds do neither.
2
See Arnott and Meckel [1991], The Policy Management Challenge: Plugging the Performance Drain, which
reviews the costs and cures of some of these elements of slippage in the fund. First Quadrant monograph, 1990, No. 6,
Robert D. Arnott and Timothy S. Meckel. Subsequently published in Global Investing, May/June 1991.
3
See Arnott and Lovell [1993], Winning in the Eighties: What It Took, which provides a sobering view of the
results achieved by the 100 largest corporate funds in the 1980s,
net of all of these costs. First Quadrant monograph, 1993, No.
3, Robert D. Arnott and Robert M. Lovell, Jr. Subsequently
published in The Journal of Investing, Fall 1993.
4
The information ratio is the ratio of the value that a
22
manager adds per year, divided by the volatility of that valueadded. If a stock manager beats the S&P by 100 basis points per
year and tracks reasonably well with the index with 4% annual
tracking error (the annualized standard deviation of the gap
between the managers performance and the benchmark), this
manager has an IR of 0.25, a reasonably respectable result.
5
If we hold stocks and short stock index futures, we should
expect a cash return, not a zero return. If we hold cash and
long stock index futures, we expect an index fund return. If the
return on the futures is the difference between the stock index
return and the cash return, both sides get what they expect. If
the pricing strays from this fair value, then one of these two
camps of investors has an arbitrage that can produce a risk-free
incremental return. Arbitrage, from either side, forces the futures
to produce returns very close to the difference between the
stock index and cash yields (specifically, the highest-yielding cash
that has a liquid market and negligible risk, e.g., LIBOR or a
repo rate).
6
How does this work? Suppose we have two managers,
each with an expected alpha of 2%, each with an expected risk
(tracking error) of 4%. The alpha is w11 + w22, while the
risk is (w1212 + w2222 + w1w21212). If the correlation
between the two strategies is high, the tracking error risk at
the portfolio level can be as much as 4%; if its low, it can be
as low as 2.8%; if its negative, it can be as low as zero (in theory, although not in practice, unless we want to hedge away
all of the alpha, too). If the alpha is 2%, regardless of mix, then
the difference between a 4% risk and a 2% risk at the portfolio level makes a huge difference in the reliability and consistency of the alpha earned by the fund.
7
If we have a 1% tracking error in one year, and 4% the
next, well find 1% variance (the square of the volatility) the
first year and 16% the next. This averages to 8.5% variance or
2.9% tracking error. Even a symmetric 1% and 3% tracking
error doesnt average to 2%; since its calculated based on variance, it averages to 2.23%.
REFERENCES
Arnott, Robert D., and Robert M. Lovell, Jr. Winning in the
Eighties: What It Took. The Journal of Investing, Fall 1993.
Arnott, Robert D., and Timothy S. Meckel. The Policy Management Challenge: Plugging the Performance Drain. Global
Investing, May/June 1991.
Markowitz, Harry M. Portfolio Selection. New Haven: Yale University Press, 1952.
To order reprints of this article please contact Ajani Malik at

amalik@iijournals.com or 212-224-3205.
SUMMER 2002

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Risk Budgeting and Portable Alphas

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Risk Budgeting

and Portable Alpha

wo of the most important developments in institutional investing

THE CLASSIC MODEL

replication strategies (e.g., collar strategies or

One of the first things we notice in this

International managers who are expected to do as

A hedge fund manager, with an interesting leveraged

No fit in fund; policy allocation to cash is zero.

*Assuming the alphas are uncorrelated.

RISK BUDGETING AND PORTABLE ALPHA

20% Hedge Fund Manager

20% Intl Bond + Currency

20% High-Yield Bond Manager

40% Domestic Stock Managers

Combined Fund Result

*Assuming the alphas are uncorrelated.

that are a bit longer in maturity and using a careful blend

What about a more ambitious decoupling of asset

Now, we have a basket of managers and strategies,

This process is actually simpler to manage, once its

20% Hedge Fund Manager

Combined Result Pre-Porting

*Assuming the alphas are uncorrelated.

RISK BUDGETING AND PORTABLE ALPHA

Rebalancing to the intended policy mix becomes

inable, without portable alpha as the basic structure. But,

Risk budgeting is an increasingly popular concept

5% Hedge Fund Manager

in effect dealing with a severely constrained optimization

RISK BUDGETING AND PORTABLE ALPHA

Even if one does not choose to move to a portable

One of the pitfalls in managing a risk budgeting

mal (i.e., statistically, a normally distributed) world.

The recognition that asset allocation and alpha are

Ive often been puzzled that funds will choose not to

RISK BUDGETING AND PORTABLE ALPHA

To order reprints of this article please contact Ajani Malik at

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