FRM Part II · FRM Exam Part II · Factors
A fund manager claims strong skill because the fund beat its broad equity benchmark by 3% over five years. A factor regression shows significant positive loadings on value and small-size factors, with insignificant alpha. What is the most appropriate conclusion?
The outperformance is mostly explained by exposure to value and size factors, with insignificant alpha. It is therefore compensation for bearing systematic factor risk, not evidence of manager skill, and could be replicated more cheaply.
- AThe outperformance mostly reflects compensation for factor exposures rather than skillCorrect
- BThe manager has demonstrated significant alpha through security selection
- CThe benchmark was mis-specified in the manager's favor and the factors are irrelevant
- DThe result proves value and size premiums are risk-free sources of return
Explanation
Significant factor loadings with insignificant alpha mean the excess return is explained by systematic exposures that could be obtained cheaply via factor products. Claiming alpha ignores this. Factor premiums are not risk-free; they carry risk and can be negative for long periods.
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