Key Takeaways
- Active risk is the difference between a portfolio’s return and its benchmark’s return, created by active management.
- Active risk is calculated either by return difference or the standard deviation of return differences over time.
- Metrics like beta, standard deviation, and Sharpe ratio help compare active risk against a benchmark.
- Residual risk is company-specific and diversifiable, while active risk is linked to active management strategies.
- Funds with high active risk seek to outperform benchmarks but come with increased risk.
What Is Active Risk?
Active risk is the extra risk a manager takes by deviating from a benchmark in an attempt to outperform, rather than simply accepting market-wide (systematic) risk. It’s often assessed with metrics like beta, standard deviation, and the Sharpe Ratio, helping investors decide whether active management is worth it versus passive exposure.
In-Depth Explanation of 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.
How to Measure Active Risk Effectively
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. If the investment returned less than 5%, the active risk would be negative, showing poor security choices or timing.
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%
Practical Example of 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) | |||
|---|---|---|---|
| Name | 3 Year Beta | 3 Year Standard Deviation | 3 Year Sharpe Ratio |
| Oppenheimer Global Opportunities Fund | 1.12 | 17.19 | 1.29 |
| MSCI ACWI | 1.00 | 10.59 | 0.78 |
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.
Comparing Active and Residual Risks
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.
The Bottom Line
Active risk is the extra risk a manager takes by deviating from a benchmark rather than investing passively. It’s measured by the return difference versus the benchmark and by the standard deviation of those differences over time, and it can help or hurt results. Unlike active risk, residual risk is company-specific and often diversifiable.