26 THEORY create portfolios that do not replicate, but rather attempt to outperform, indexes.

This is an important distinction. The difference between a passive manager and an active manager can be compared to the difference between a housepainter and an artist. Both work with paint, but they do two completely different jobs, and they get paid very differently. Active managers do not get paid fees for creating passive exposures to broad asset classes. To pay an active fee for benchmark returns would be like paying an expensive artist to paint the walls of a room a solid color-it could be done, but it would be a waste of money. Active managers earn their fees for taking risk relative to a benchmark, referred to as active risk. Active managers deviate from benchmarks in an attempt to outperform their benchmark. These deviations are the artistry that the active managers use to create the opportunity to outperform the benchmark, but they also create the risk that the manager may underperform. It is the expectation of outperformance generated by active risk, not the exposure to the market risk embedded in the benchmark, that justifies active management fees. Clearly, active risk should be taken only when there is an expected positive net return (after fees and after taxes) associated with it. Just like artists, active managers come in many different styles. Some are very conservative; they take very little active risk and have very low fees. Others take lots of active risk and charge high fees. A common terminology for referring to active management styles, in order of increasing risk, is as follows: enhanced, structured, and concentrated. We emphasize the distinction between total risk and active risk because it is a key element in the design and overall management of portfolios. Asset allocation balances the risks and returns embedded in benchmarks; risk budgeting revolves around making decisions between passive and active management, choosing different styles of active management, and allocating and balancing the active risk that is created when active managers are grouped together. In the portfolios of most investors, the dominant risk and source of return comes from asset allocation decisions and exposures to broad market indexes. The active risk in a portfolio, representing the aggregation of all deviations from benchmarks, is generally a small contributor to overall portfolio risk and return. When managed carefully it can be an important source of positive returns relative to the benchmark, but otherwise it can be a costly source of risk and underperformance. Too often portfolio construction is a bottom-up by-product of decisions made about individual managers, funds, or other investment products. Each such decision should not be made independently; rather portfolio construction should start with a top-down asset allocation-the determination of allocations to different broad asset classes. Only after the asset allocation is determined should the implementation decisions be made. The decisions about which products to put into a portfolio and from whom should be part of this process we call risk budgeting. The choices that need to be made as part of the risk budgeting implementation plan include for each asset class: II What benchmark or benchmarks to use. II How much of the portfolio to allocate to index products versus active managers. II What types of styles of active managers to invest in. ill How many managers to hire or funds to invest in.

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