Active risk

Why is lower correlation increases active risk?

Lower correlations with your portfolio and and the benchmark?

Well… think about it. the returns are now FAR MORE LIKELY to be different - even on a daily basis - which means the standard deviation of the active returns will widen.

edit: Here’s another way to think about it, if your portfolio was “perfectly” correlated with the benchmark, active risk would be zero. because there would never be any active return (Rp - Rb) = 0 … and the standard deviation of zero is zero. But, as these correlations break down, and we introduce active return into the portfolio, Rp - Rb will no longer ALWAYS equal zero, which increases active risk (on all time frames where before hand we had a perfectly correlated portfolio).

This is a guess, but you can also think about the actual correlation equation (Cov1,2) / (standard deviation1 x standard deviation2). As the denominator gets bigger, correlation will get smaller…