RESIDUAL RISK - HOW MUCH IS TOO MUCH

The optimal level of residual risk for a portfolio is the level that a llows the portfolio to provide the highest expected return the manager can generate within the limits of the investor's risk tolerance param eters. As it is not always easy to determine investor risk tolerance o r manager ability to add value, portfolios are often ''pigeonholed'' a ccording to residual risk levels alone. ''Enhanced passive'' or ''inde x-plus'' portfolios, for example, are expected to offer excess returns of up to 1% at residual risk levels not to exceed 2%. But such artifi cial constraints as a 2% bound on residual risk can lead to selection of suboptimal portfolios. In particular, they can lead investors to as sume too little risk, hence allow too little expected return, for thei r actual risk tolerances, or to accept less skillful managers when mor e highly skilled managers are available. They may also encourage subop timal manager behavior.