Risk policy, summary Practice document Page 1 of 2
Larch Balanced Europe Fund Risk management policy · a UCITS fund · made up for this lesson
The risk budget The board sets the fund’s risk limits before the manager chooses what to hold. A new position goes in only if the budget has room.1
Single companies No company may weigh more than 10% of the fund, and holdings above 5% may not add up to more than 40% together.2
Distance from the benchmark Expected tracking error against the benchmark stays within 1.25 percentage points a year.3
Holdings that move together Before adding a holding, the manager checks how closely it moves with the others.4
Bad days If the fund falls 15% below its peak, the manager cuts risk.5
This paper is made up for Red Start Education and describes no real fund. Past performance does not predict future returns.
Line 1 · The budget
Risk as a budget “The board sets the fund’s risk limits before the manager chooses what to hold. A new position goes in only if the budget has room.”
A risk budget is a limit set in advance: how far the fund may fall, how much it may swing, how much one holding may weigh. Every new position spends some of it. When the budget is used up, nothing new goes in until something comes out.
It lets the manager Add anything that fits the room left It never may Add a position the budget has no room for Read it slowly Limits first, holdings second: that order is the whole habit.
Check it yourself Write three limits of your own: the deepest fall, the most one holding may weigh, the swings you can live with.
Line 2 · One company
The rule every UCITS fund lives by “No company may weigh more than 10% of the fund, and holdings above 5% may not add up to more than 40% together.”
European law caps how much a UCITS fund may hold in one company: normally 5%, up to 10% at most, and the holdings above 5% may not add up to more than 40% together. A fund with five holdings at 9% each would break the rule, because 45% sits in its big positions.
It lets the manager Hold one company up to 10% Keep several above 5%, up to 40% together It never may Put more than 10% in one company Let its big positions pass 40% Read it slowly Each holding can pass on its own while the group fails: the 40% is a limit on the big ones together.
Check it yourself Find your own largest holding and your five largest together.
Source: UCITS Directive 2009/65/EC, article 52
Line 3 · How far from the plan
A fence around the manager’s ideas “Expected tracking error against the benchmark stays within 1.25 percentage points a year.”
Big funds also budget how far they may stray from their benchmark. Norway’s fund may differ from its index by no more than 1.25 percentage points of expected tracking error a year. This made-up fund uses the same fence. It is a fence around the manager’s own ideas.
It lets the manager Back its own ideas, inside 1.25 points It never may Stray further from the benchmark than that Read it slowly The number on this made-up paper is a real one: Norway’s oil fund lives by it.
Check it yourself If your own fund names a benchmark, find its tracking error in the factsheet.
Source: Norway’s fund mandate (Ministry of Finance), via nbim.no
Line 4 · Moving together
Ten holdings, one bet “Before adding a holding, the manager checks how closely it moves with the others.”
Ten holdings that all rise and fall together are closer to one bet than to ten. Funds watch correlation, how closely holdings move together, because spreading only works between things that do not move as one.
It lets the manager Add holdings that move in their own way It never may Count ten look-alikes as ten bets Read it slowly Count the bets, not the names.
Check it yourself Look at your own holdings on a bad day: how many fell together?
Line 5 · Bad days
A rule written on a calm day “If the fund falls 15% below its peak, the manager cuts risk.”
Many funds write down in advance what they will do after a set fall, such as cutting risk once the fund is 15% below its peak. A rule decided on a calm day is easier to follow than a choice made in a panic.
It lets the manager Cut risk by rule after a 15% fall It never may Make up the plan in the middle of the fall Read it slowly A rule is only worth having if you would follow it. Test one on real prices first.
Check it yourself Find the deepest fall your own portfolio has had, and write the rule you would want for the next one.