The section in the text that discussed allocating funds to managers (LOS 32q) states that investors are more risk averse when facing active risk than total risk. Could someone please explain the difference between the two and why the position taken by the investor. The way it is stated in the text does not help my understanding so a more practical explanation is required.
Active risk: Volatility/deviation of active return from mean active return. Total risk: Systematic risk + unsystematic risk I am not sure if we can classify active risk as systematic or unsystematic or both, but I believe unsystematic risk provides more opportunities for earning alphas-active return. Hypothetical example Assume the trustees of XYZ pension fund hires 5 managers to manage its pension fund/portfolio. Manger A: Specialize in indexing, Manger B: Specialize in indexing/enhance indexing, Manger C, D, E: Active managers. Managers A&B are managing the core portfolio, their main objective is to control and manage risk. Active managers are responsible for generating active return (called satellites). Now, they will comparatively take more risks than the other mangers to earn alphas. Overall, the Pension fund should experience the benefit of diversification resulting in the total fund risk being less than the total active risk. Therefore, in general investors are expected to be more risk averse when facing active risk than total risk.
active risk is just your tracking error (or alpha risk) total risk is both beta risk and alpha risk combined. or you can look at Total Risk as described above (i.e., text book description) investors are risk adverse with active risk (than compared to total risk) because they are usually benchmark focused. For example, I rather avoid a strategy that has a TE of 10% even if the STD is only at 20% (low) and choose another with a TE of 2% (low) but has a std of 30% (high) because my intention is, say, to capture more of the “benchmark return” (i.e. beta return). hope that doesn’t confuse you even more. lol
Let’s say your benchmark is the SPX. Investors will be very upset if they lose 10% but the market rallied than if they lose 10% but it’s because the whole market went down. So basically, it’s better if everyone sucks than if you alone suck.