Risk budgeting primer

October 2024

For CIOs, investment staff, and trustees tasked with assessing the risk of a capital pool, risk budgeting provides a structured approach. This practice involves setting a “budget” for risk and then allocating and monitoring that risk across the portfolio. Unlike traditional capital allocation, which focuses on distributing capital across asset classes, risk budgeting emphasizes the allocation of risk itself.

Risk budgeting can be applied at the total portfolio level or at the asset class level. There are two types of risk budgets. The first involves determining the contribution to the overall level of risk. The second, more common, approach looks at how much a portfolio contributes to risk relative to a benchmark. This specific method, known as “active risk budgeting,” guides portfolio decisions by incorporating a benchmark or index as a point of comparison. Through this approach, investors may be able to better manage active risk within their portfolios, helping to steer portfolio construction.

This paper focuses on risk budgeting at the active risk level, examining how active risk is allocated and managed within a portfolio. We will explore the concept of active risk, why it exists in portfolios, and the expected outcomes for investors based on different levels of active risk exposure.