Remember to Diversify Your Active Risk: Evidence from US Equity ETFs

Abstract

In this article, the authors estimate the level of risk diversification for a universe of US equity exchange-traded funds (ETFs) and observe the benefits of diversification for the budgeting of active risk relative to a cap-weighted benchmark. They first introduce a risk model that needs only historical returns to break down relative risk into individual factor-related risk contributions, thus allowing for the construction of a measure of concentration directly inspired by the equally weighted risk contribution concept. They then use this concentration measure to highlight the impact of diversification on tracking-error stability and find conclusive empirical evidence that US equity ETFs that have a diversified set of systematic active risk contributions have a more stable tracking error (TE). These results suggest that investors seeking a stable TE for active risk–budgeting purposes may benefit from selecting ETFs with a strong level of risk diversification.