What does active risk budgeting aim to address?

Active risk budgeting is primarily focused on determining and managing the amount of risk an active manager is willing to take relative to a benchmark in order to achieve outperformance. It involves strategizing how much risk to allocate across various assets in pursuit of excess returns compared to a market index. The concept of active risk, or tracking error, is essential because it quantifies the deviation of the portfolio's returns from the benchmark's returns. By explicitly budgeting this risk, asset managers can make informed decisions on where to invest and how much to deviate from the benchmark, effectively aiming to optimize their chances of delivering excess returns while keeping risk within a defined tolerance range.

This approach contrasts with other options, such as minimizing portfolio variance, which focuses solely on total risk rather than benchmark-relative risk. Maximizing asset ownership does not directly relate to risk budgeting, and reducing trading costs, while important, is not the primary goal of active risk budgeting. Instead, the core objective is balancing risk with the potential for achieving returns that exceed those of a benchmark.