Active Risk

What Is Active Risk?

Active risk is a type of risk that a fund or managed portfolio creates as it attempts to beat the returns of the benchmark against which it is compared. Risk characteristics of a fund versus its benchmark provide insight on a fund’s active risk.

Understanding Active Risk

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. Generally, passively-managed funds seek to have limited or no active risk in comparison to the benchmark they seek to replicate.

Active risk can be observed through a comparison of multiple risk characteristics. Three of the best risk metrics for active risk comparisons include beta, standard deviation or volatility, and Sharpe Ratio. Beta represents a fund’s risk relative to its benchmark. A fund beta greater than one indicates higher risk while a fund beta below one indicates lower risk.

Standard deviation or volatility expresses the variation of the underlying securities comprehensively. A fund volatility measure that is higher than the benchmark shows higher risk while a fund volatility below the benchmark shows lower risk.

The Sharpe Ratio provides a measure for understanding the excess return as a function of the risk. A higher Sharpe Ratio means a fund is investing more efficiently by earning a higher return per unit of risk.

Measuring Active Risk

There are two generally accepted methodologies for calculating active risk. Depending on which method is used, active risk can be positive or negative. The first method for calculating active risk is to subtract the benchmark's return from the investment's return. For example, if a mutual fund returned 8% over the course of a year while its relevant benchmark index returned 5%, the active risk would be:

Active risk = 8% - 5% = 3%

This shows that 3% of additional return was gained from either active security selection, market timing, or a combination of both. In this example, the active risk has a positive effect. However, had the investment returned less than 5%, the active risk would be negative, indicating that security selections and/or market-timing decisions that deviated from the benchmark were poor decisions.

The second way to calculate active risk, and the one more often used, is to take the standard deviation of the difference of investment and benchmark returns over time. The formula is:

Active risk = square root of (summation of ((return (portfolio) - return (benchmark))² / (N - 1))

For example, assume the following annual returns for a mutual fund and its benchmark index:

Year one: fund = 8%, index = 5%
Year two: fund = 7%, index = 6%
Year three: fund = 3%, index = 4%
Year four: fund = 2%, index = 5%

The differences equal:

Year one: 8% - 5% = 3%
Year two: 7% - 6% = 1%
Year three: 3% - 4% = -1%
Year four: 2% - 5% = -3%

The square root of the sum of the differences squared, divided by (N - 1) equals the active risk (where N = the number of periods):

Active risk = Sqrt( ((3%²) + (1%²) + (-1%²) + (-3%²)) / (N -1) ) = Sqrt( 0.2% / 3 ) = 2.58%

Example Using Active Risk Analysis

The Oppenheimer Global Opportunities Fund is a good historical example of a fund that outperformed its benchmark with active risk, and it is useful for illustrating the concept.

The Oppenheimer Global Opportunities Fund is an actively managed fund that seeks to invest in both U.S. and foreign stocks. It uses the MSCI All Country World Index as its benchmark. For the year 2017, it recorded a one-year return of 48.64% versus a return of 21.64% for the MSCI All Country World Index.

Oppenheimer Global Opportunities Fund (data for year-end 2017)

3 Year Beta

3 Year Standard Deviation

3 Year Sharpe Ratio

Oppenheimer Global Opportunities Fund

The Fund's beta and standard deviation show the active risk added in comparison to the benchmark. The Sharpe Ratio shows that the Fund is generating higher excess return per unit of risk than the benchmark.

Active Risk vs. Residual Risk

Residual risk is company-specific risks, such as strikes, outcomes of legal proceedings, or natural disasters. This risk is known as diversifiable risk, since it can be eliminated by sufficiently diversifying a portfolio. There isn't a formula for calculating residual risk; instead, it must be extrapolated by subtracting the systematic risk from the total risk.

Active risk arises through portfolio management decisions that deviate a portfolio or investment away from its passive benchmark. Active risk comes directly from human or software decisions. Active risk is created by taking an active investment strategy instead of a completely passive one. Residual risk is inherent to every single company and is not associated with broader market movements.

Active risk and residual risk are fundamentally two different types of risks that can be managed or eliminated, though in different ways. To eliminate active risk, follow a purely passive investment strategy. To eliminate residual risk, invest in a sufficiently large number of different companies inside and outside of the company's industry.