Explanation:
When the forecasted tracking error is consistently lower than the target established by the investment mandate, it indicates that the portfolio manager may not be taking enough active risk as expected by the investors and the mandate. While lower risk might seem beneficial, investors in active funds expect a certain level of active risk (reflected by the tracking error target) to generate outperformance (alpha). A lower-than-target tracking error suggests the fund is hugging the benchmark too closely.
The most appropriate initial action is for the Risk Management Unit (RMU) to discuss these findings with the portfolio manager and senior management to understand the rationale behind the conservative positioning and to evaluate if portfolio adjustments are needed to realign with the mandate's target.
A is incorrect because the RMU typically advises and monitors rather than immediately instructing portfolio managers on specific investment actions without prior discussion. B is incorrect because the RMU has already identified the cause of the lower tracking error (the portfolio manager's conservative approach), so the model is functioning correctly. D is incorrect because investors pay for active management expecting a specific risk-return profile; a tracking error that is too low means the fund is not meeting its investment mandate.
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Q.2537 Phoenix Capital, a prominent asset management firm, has a successful Emerging Markets Equity Fund. Their Risk Management Unit (RMU) uses a proprietary model to estimate a forecasted tracking error. Recently, the RMU noticed that the forecasted tracking error for the fund was consistently lower than the target established by the firm's investment mandate. The RMU identified that this is due to the fund's portfolio manager having a more conservative approach and holding a larger proportion of assets in stable, less volatile securities. Which of the following actions is most appropriate for Phoenix Capital's RMU in response to this finding?
A
Immediately instruct the fund's portfolio manager to invest in more volatile securities to increase the tracking error to the target level.
B
Initiate a review of the proprietary risk forecasting model to ensure it is functioning correctly.
C
Discuss the findings with the fund's portfolio manager and senior management to understand the reasons and evaluate the need for any portfolio adjustments.
D
No action is required as a lower tracking error means less risk, which is beneficial for the investors.