Risk Budgeting
Risk budgeting allocates risk capacity across strategies and managers—not just dollars. It controls drawdown tolerance, correlation overlap, concentration, and illiquidity.
Risk budgeting is the allocator discipline of deciding how much portfolio risk is acceptable and where that risk is allowed to come from. Rather than focusing only on capital weights, risk budgeting focuses on risk drivers: equity beta, credit risk, duration exposure, factor correlations, leverage, liquidity mismatch, and concentration.
From an allocator perspective, many portfolios fail not because they chose “bad managers,” but because they unknowingly concentrated the same risk across multiple wrappers.
How allocators define risk budgeting risk drivers
Allocators evaluate:
- Downside tolerance: drawdown limits and stress scenarios
- Correlation overlap: factor exposure and clustering risk
- Concentration limits: per manager/strategy/theme
- Illiquidity tolerance: lockup risk vs liquidity needs
- Leverage/convexity: where losses can accelerate
- Governance triggers: what forces risk reduction
- Measurement discipline: how risk is monitored over time
Allocator framing:
“Does this manager add differentiated return—or just repackage existing risk?”
Where risk budgeting matters most
- multi-manager alternatives portfolios
- crisis regimes when correlations rise
- portfolios scaling illiquids and co-invest programs
- governance-sensitive allocators with limited drawdown tolerance
How risk budgeting changes outcomes
Strong risk budgeting:
- prevents hidden factor concentration
- supports stable pacing and rebalancing behavior
- reduces panic-driven changes in stress
- improves portfolio resilience and decision confidence
Weak risk budgeting:
- creates surprise drawdowns and governance backlash
- triggers commitment freezes and manager churn
- increases regret and inconsistency
- makes diversification look real until it isn’t
How allocators evaluate risk discipline
Conviction increases when allocators:
- define explicit limits and actions when breached
- run scenario tests and identify “what breaks the plan”
- link risk budgets directly to manager selection and sizing
- reduce exposures consistently when limits are hit
What slows allocator decision-making
- risk described qualitatively with no measurement
- no factor/correlation understanding
- treating illiquidity as “just another allocation”
- no plan for what happens when limits are breached
Common misconceptions
- “Diversification equals safety” → correlated diversification fails in stress.
- “Risk budgeting is for quants” → it’s for governance survival.
- “Illiquids reduce volatility” → they often delay recognition, not remove risk.
Key allocator questions during diligence
- What risk limits govern this allocation (drawdown, concentration, liquidity)?
- What overlap exists with existing exposures?
- What scenarios are most damaging and what actions follow?
- How is risk measured and monitored operationally?
- What triggers a reduction or termination?
Key Takeaways
- Risk budgets allocate risk drivers, not narratives
- Correlation overlap is the most common hidden failure
- Explicit triggers and actions are the discipline test