TILT: A framework for active risk budgeting
Figure 8 illustrates our TILT (Targets, Inputs, Limits, Transform) framework, which allocators can use to help incorporate research insights from this paper into their own active risk budgeting processes. Below we highlight a few key points.
Targets: Allocators first need to set an overall active risk target for their portfolio. This will lay the groundwork for decisions about AA and SS active risk sources.
Inputs: As outlined in this paper, there are three key inputs into an active risk budgeting process: the amount of active risk that can be achieved from different sources, the IR assumption for each source, and the relationship and interaction between the sources.
Limits: Allocators will likely have practical limits that need to be incorporated into an active risk budgeting process. For example, they may limit the number or weight of different active risk sources. They may also limit the use of leverage, which we find can typically be more easily applied to active AA strategies, as SS strategies can quickly reach practical limits (e.g., on collateral, fees, and capacity).
Transform: The final step is to transform the targets, inputs, and limits into portfolio weights. We do not see this as a “one size fits all” process. Typically, the targets, inputs, and limits would be used to generate an initial estimate of strategy weights, which would then be subject to testing — including how the combined strategies may impact expected portfolio outcomes. The weights would then be adjusted, tested, and readjusted until the desired risk/return profile is achieved. Allocators can also test for changes in the inputs (e.g., correlation between strategies) and for outcomes during market stress periods. We also think allocators should aim to stress-test each weight combination to ensure the limits are not breached, the weights align with intuition about where active risk should be taken, and the expected portfolio outcomes meet the targets.