Chartered Financial Analyst (CFA) Practice Exam Level 2

What does Active Risk (IR) measure in investment performance?

1. The volatility related to specific investments

2. The difference in expected return versus the market return

3. The risk of default by the issuer

4. The overall market risk

The correct answer is: The volatility related to specific investments

Active Risk, often referred to in the context of investment performance evaluation, measures the volatility of an investment portfolio's returns relative to a benchmark index. Specifically, it captures the degree of deviation of a portfolio's returns from the returns of that benchmark due to active management decisions. Active Risk is typically expressed as the standard deviation of the difference in returns between the portfolio and the benchmark. By focusing on the variability associated with active management, it provides insight into how much risk the portfolio manager is introducing beyond what would be expected from simply holding the benchmark. This measure helps assess the effectiveness of active investment strategies and management. The other options refer to different risk concepts. While volatility is indeed part of what Active Risk assesses, the difference in expected return versus market return relates more to concepts like alpha. Risk of default pertains to credit risk, which is unrelated to the notion of Active Risk, and overall market risk usually encapsulates systematic risk, not the specific variability linked to active management strategies.