Active Risk versus Total Risk

CFA Level III
#1

According to Schweser material and the text, investors are FAR more risk averse in active risk terms than total risk terms and lists 3 reasons (see below). But, the explanations are evidence of aversion to active risk and NOT reasons for why they are FAR more risk averse in active risk compared to total risk. Can someone elaborate in a different way why total risk is LESS risk averse?

Reasons:

  1. To believe that a positive active return is possible, the investor would haveto be confident they could select the manager that offers the highest active return.

  2. Managers are often times measured against some passive benchmark. Because they believe it’s difficult to beat a passive benchmark, they won’t stray too far from the benchmark

  3. If the investor wants the highest return, they would have to invest more money with the active manager who has the highest active return thereby resulting in less diversification.

#2

these reasons are not present when considering total risk, this is why they attest to the fact that managers are far more risk averse in active risk terms than total risk terms

#3

I see your point about the reasons provided by the text (copied/echoed verbatim by Schweser):

  1. To capture the highest active return, one has to be active risk-aggresive – doesn’t say about relative aversion between active risk and total risk

  2. If it is difficult to beat the benchmark (i.e. capture active return), why take some active risk (i.e. active risk aversion)

  3. This reason is a consequence of 1 above – investor will max out allocation to highest active return – reducing diversification --so what? – doesn’t say about relative aversion between active risk and total risk

Conclusion: Sometimes the text explanation does not make sense (we call that BS in MBA school) or that could just be beyond us. For me, it is the former :slight_smile: and I am an extremely intelligent guy :slight_smile:

#4

i am not sure whether this is right or not, but here’s my logic: investors know they have to take risk to get return. But they’ll be more comfortable taking the average market level of risk, than they will be to “go out on a limb” and try to get additional returns with active risk. Herding behaviour – it’s easier to be wrong in a big group, than to have gone out on your own and ended up underperforming…