Structural positions and risk budgeting: Quantifying the impact of structural positions and deriving implications for active portfolio management

Structural positions are very common in investment practice. A structural position is defined as a permanent overweighting of a riskier asset class relative to a prespecified benchmark portfolio. The most prominent example for a structural position is the equity bias in a balanced fund that arises by consistently overweighting equities in tactical asset allocation (TAA). Another example is the permanent allocation of credit in a fixed income portfolio with a government benchmark. We use graphical illustrations based on the Pythagorean theorem to make a connection between the active risk/return and the total risk/return framework and show that structural positions alter the risk profile of the portfolio substantially. The appeal of active management — to provide active returns uncorrelated to benchmark returns and hence to shift the efficient frontier outwards — gets lost. TAA should be based on the comparison of expected excess returns of an asset class to the equilibrium risk premium of the same asset class and not to expected excess returns of other asset classes. For the cases where structural positions cannot be avoided, a risk budgeting approach is introduced and applied to determine the optimal position size.