Residual Risk: How Much is Too Much?

Abstract

The optimal level of residual risk for a portfolio is the level that allows the portfolio to provide the highest expected return the manager can generate within the limits of the investor's risk tolerance parameters. As it is not always easy to determine investor risk tolerance or manager ability to add value, portfolios are often “pigeonholed” according to residual risk levels alone. “Enhanced passive” or “index-plus” portfolios, for example, are expected to offer excess returns of up to 1% at residual risk levels not to exceed 2%. But such artificial constraints as a 2% bound on residual risk can lead to selection of suboptimal portfolios. In particular, they can lead investors to assume too little risk, hence allow too little expected return, for their actual risk tolerances, or to accept less skillful managers when more highly skilled managers are available. They may also encourage suboptimal manager behavior.

Keywords: Residual Risk, Risk Aversion, Regret Aversion, Tracking Error, Portfolio Management, Portfolio Construction, Information Ratio, Enhanced Passive Portfolios, Index-Plus Portfolios, Enhanced Indexing, Manager Skill, Risk Constraints, Investor Utility

JEL Classification: G11