Active Risk, Tracking Risk and Information Ratio - CFA, FRM, and Actuarial Exams Study Notes (2024)

FAQs

What is the active risk in CFA Level 3? ›

Active risk = tracking error. It's the difference in the standard deviation of returns on the portfolio vs. that of the benchmark. Active share = the number of active decisions made by the manager to overweight/underweight securities.

Active Share measures the extent to which the number and sizing of positions in a manager's portfolio differ from the benchmark. Benchmark-agnostic managers usually have a greater level of Active Share and most likely have a greater level of active risk. effectively allocate risk among individual positions/factors.

Active risk is the standard deviation of active returns. Active risk is also called tracking error or tracking risk. Active risk squared can be decomposed as the sum of active factor risk and active specific risk.

The Sharpe ratio compares the return of an asset against the return of Treasury bills; the information ratio compares excess return to the most relevant equity (or debt) benchmark index. The information ratio helps investors focus on the relative value added by active management.

This shift from the traditional multiple-choice format to a more application-based approach is often cited as one of the primary reasons why the CFA Level 3 exam is considered more challenging than Levels 1 and 2.

Major activity ratios include inventory turnover, days of inventory on hand, receivables turnover, days of sales outstanding, payables turnover, number of days of payables, working capital turnover, fixed asset turnover, and total asset turnover.

Active risk (tracking error) measures the volatility of the return difference (excess return) between a portfolio and its benchmark. If an investor wishes to outperform their benchmark, the portfolio composition must be different than that benchmark.

The information ratio is used to evaluate the skill of a portfolio manager at generating returns in excess of a given benchmark. A higher IR result implies a better portfolio manager who's achieving a higher return in excess of the benchmark, given the risk taken.

Here's the formula: Active Risk (Tracking Error) = Standard Deviation (Portfolio Returns-Benchmark Returns) To calculate the tracking error, follow these steps: Gather the historical returns of the investment portfolio over a specific period.

What is the formula for calculating active risk? ›

The formula for arriving at the optimal amount of active risk to hold in a portfolio is given as (ST_DEV(Ra) = (IR/SR(benchmark)) * ST_DEV(Rb).

The Information ratio acts as a measure of a fund manager's performance. Fund managers, therefore, use IR or appraisal ratio, to determine their service charges. The better a portfolio manager's ratio, the higher is their service charge.

Understanding the Sharpe Ratio

Usually, any Sharpe ratio greater than 1.0 is considered acceptable to good by investors. A ratio higher than 2.0 is rated as very good. A ratio of 3.0 or higher is considered excellent. A ratio under 1.0 is considered sub-optimal.

A Sharpe ratio less than 1 is considered bad. From 1 to 1.99 is considered adequate/good, from 2 to 2.99 is considered very good, and greater than 3 is considered excellent. The higher a fund's Sharpe ratio, the better its returns have been relative to the amount of investment risk taken.

The constructed-response section of the Level III CFA exam is the biggest difference from the Level II CFA exam. These response questions are open-ended, which require constructed answers without multiple choices to pick from.

Active risk is the risk a manager takes on in their efforts to outperform a benchmark and achieve higher returns for investors. Actively managed funds will have risk characteristics that vary from their benchmark.

Active factor risk is the risk due to portfolio's different-than-benchmark exposures relative to factors specified in the risk model. Active specific risk are risks resulting from the portfolio's active weights on individual assets. It is also known as asset selection risk.

Standard Deviation:

The formula calculates the squared differences between each individual return and the mean return, averages them, and then takes the square root of the result to obtain the standard deviation, which represents the Active Risk of the portfolio.

Value at Risk (VaR) is a statistic that is used in risk management to predict the greatest possible losses over a specific time frame. VAR is determined by three variables: period, confidence level, and the size of the possible loss.