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An active risk is the amount of volatility associated with a specified portfolio or fund as the investment is attempting to surpass the amount of returns identified as a benchmark for that asset. The idea is that in order to achieve this goal, the manager of the fund or portfolio must voluntarily take on risk above and beyond the risk required to simply equal the benchmark. When considering any type of investment activity as a means of beating the benchmark returns, the manager must also consider the amount of active risk that he or she is assuming on behalf of the portfolio or fund.
The concept of active risk is closely associated with active investing. This approach to investing is simply the process of closely managing the assets held within a portfolio and taking aggressive and timely steps to enhance the value of that portfolio. Active investing is different from passive investing, in that the passive approach calls for acquiring investments that are anticipated to consistently generate a decent amount of return, rendering the need to closely manage those assets unnecessary.
Since the goal of active investing is to aggressively manage assets and increase the value of the securities held in a portfolio or fund, the process requires managers to be willing to accept additional risks. In order to accomplish this goal, managers must look closely at the risk-return tradeoff, determining if the degree of risk involved in the acquisition of a given asset is worth the amount of return that is ultimately generated by that asset. Should the manager determine that a given security carries a high degree of risk with only a mediocre potential return, he or she is likely to avoid that particular investment. At the same time, if an option does carry a higher level of risk but also has the potential to generate significant returns, the manager may consider the degree of active risk within reason, and take steps to acquire that option.
Identifying the active risk associated with any investment requires setting what the investor considers a benchmark for the performance of that asset. The process also calls for making decisions that are not necessarily based on the projections of the market’s movement in general. Often, active risk is present when a manager has reason to believe a given asset will outperform similar assets in the marketplace due to some type of unusual events that will occur in the short-term. By timing the purchase of those assets so they are in hand just before the anticipated events, the manager is able to generate a greater amount of return for as long as those events continue to impact the value of those assets. The manager further enhances the returns by accurately determining when to sell those assets and avoid any losses that may take place when the prices begin to settle into a pattern that is more in keeping with the current market trend.