Explanation:
Tracking error indicates the aggregate relative risk against a benchmark, but it does not tell the whole story about where the risk is originating. An over-budget scenario in specific sectors with offsets in other areas implies that the manager is taking concentrated active bets that may deviate from the fund's established investment strategy and mandate. A rigorous risk monitoring process should detect and challenge these structural deviations (style/theme drift) rather than just validating the aggregate tracking error.
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Q.75 Allegro Investments, a renowned investment management firm, sticks to a rigorous risk monitoring process. Recently, their Risk Management Unit (RMU) found out that one portfolio manager is generating a forecasted level of tracking error, which aligns perfectly with the target established by the mandate. However, the same manager is found to be significantly over budget in specific sectoral themes with offsets in other areas. As the Chief Risk Officer at Allegro Investments, how should you assess this situation?
A
The situation is not problematic since the overall forecasted tracking error is aligned with the target.
B
The overspending in specific sectors is a matter of the manager's discretion and should not be intervened.
C
The over-budget scenario in specific sectors indicates potential deviations from the established investment strategy.
D
This situation suggests that the risk forecasting model is not functioning correctly.
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