LO 69.7: Describe how risk monitoring can confirm that investment activities are consistent with expectations.
Is the manager generating a forecasted level o f tracking error that is consistent with the target?
The forecasted tracking error is an approximation of the potential risk of a portfolio using statistical methods. For each portfolio, the forecast should be compared to budget using predetermined guidelines as to how much variance is acceptable, how much variance requires further investigation, and how much variance requires immediate action. Presumably, the budget was formulated taking into account client expectations.
Tracking error forecast reports should be produced for all accounts that are managed similarly in order to gauge the consistency in risk levels taken by the portfolio manager.
Is risk capital allocated to the expected areas?
Overall tracking risk is not sufficient as a measure on its own; it is important to break down the tracking risk into subsections. If the analysis of the risk taken per subsection does not suggest that risk is being incurred in accordance with expectations, then there may be style drift. Style drift may manifest itself in a value portfolio manager who attains the overall tracking error target but allocates most of the risk (and invests) in growth investments.
Therefore, by engaging in risk decomposition, the RMU may ensure that a portfolio managers investment activities are consistent with the predetermined expectations (i.e., stated policies and manager philosophy). Also, by running the report at various levels, unreasonably large concentrations of risk (that may jeopardize the portfolio) may be detected.
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