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Improving the optimal allocation between risk and return.
Investors have typically approached the asset allocation decision in two stages. First, the optimal allocation to each broad asset class is determined-often using a mean-variance optimization process based on that proposed by Markowitz [1952]. Once the optimal allocation has been determined, active and passive managers are selected to implement the allocation within each asset class.
In recent years, many have advocated the use of alternative assets and hedge funds as a separate asset class. We propose an alternative framework to look at risk that frames the allocation decision in a way that does not consider asset classes per se. We begin by distinguishing between two different sources of risk in an investment portfolio: systematic risk and active risk. The allocation decision can then be framed in the context of how much systematic and active risk the investor wants in the portfolio, and the most effective way to put the portfolio together.
The risk allocation framework allows the investor more flexibility in controlling the sources of risk in the portfolio, and can lead to a more efficient trade-off between risk and return than the traditional asset allocation framework.
SYSTEMATIC VERSUS ACTIVE RISK
To develop the risk allocation framework, we separate risk into two general types depending on the source systematic risk, which comes from marketwide influences, and active risk, which cannot be explained by marketwide factors. In this framework, active risk represents the residual risk of an investment. The risk of a security or a portfolio can be described by: its exposure to systematic factors, the volatility of those systematic factors, and the residual or active risk.
Typical sources of systematic risk exposures identified in the financial literature include:
*Broad equity market exposure
*Exposure to the book-to-price or value factor
*Exposure to the market capitalization factor
*Exposure to interest rate changes
*Exposure to default risk
There has been much debate over whether all these are indeed true sources of systematic risk, and whether there is a marketwide risk premium associated with each one. We leave the details of that debate aside for now, only to note that these sources of systematic risk are generally described as driven by marketwide influences, as well as that the investor can...