In comparing the two most recent quarterly reports, he notices differences in holdings that indicate that Fund 3 executed two trades, with each trade involving pairs of stocks. Initially, Fund 3 held active positions in two automobile stocks—one was overweight by 1 percentage point (pp), and the other was underweight by 1pp. Fund 3 traded back to benchmark weights on those two stocks. In the second trade, Fund 3 selected two different stocks that were held at benchmark weights, one energy stock and one financial stock. Fund 3 overweighted the energy stock by 1pp and underweighted the financial stock by 1pp.
As a result of Fund 3’s two trades, the portfolio’s active risk most likely— the answer is increased. Why? I thought high correlations contribute to higher active risk? I have read some posts on this and remain confused. Can someone please dumb this down for me?
With the first pair - intra sector both auto - you are taking mainly stock risk - Ford vs GM. All the factors that effect auto companies are effecting both stocks. We are left with is the Ford motor company doing better than GM.
With the second pair you are also taking sector risk - banks verus oil and gas - JP Morgon v Exxon. Now we have a lot more factors that can move the difference in these two prices.
This is a good question, and it’s more conceptual than quantitative.
Active risk is defined by two factors: variance in factors+ variance in individual stocks.
In the first example, automotive equities are roughly the same factor (this is a simplification), so the main variance would be from idiosyncratic risks.
In the second example, equities from different sectors would likely have greater variance in factor+variance in the individual stocks.
Thus, don’t focus on mere correlations between the equities, but focus on the sources of variance which define active risk.