FRM Part II · FRM Exam Part II · Factor Theory
A fund combines a value tilt and a momentum tilt in a single smart beta strategy. Historically value and momentum returns have been negatively correlated. Relative to holding either factor alone, the combined strategy most likely:
The combination likely has lower volatility and smaller drawdowns for similar expected return, because value and momentum returns are negatively correlated and diversification reduces portfolio variance. The exposures do not cancel out; each premium is still partly earned.
- AHas higher volatility because two risk sources are added
- BHas lower volatility and smaller drawdowns for a given expected return because of diversification across factorsCorrect
- CHas the same volatility because factor premiums are independent of correlation
- DHas no exposure to either factor because the tilts cancel exactly
Explanation
Negative correlation between factor returns reduces portfolio variance, improving the risk-return tradeoff. The tilts do not cancel exposures to the extent of eliminating premiums. Volatility is lower, not higher or unchanged.
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