FRM Part II · FRM Exam Part II · Portfolio Construction
A fund manager wants a smart beta equity portfolio that harvests the low-volatility factor without large unintended exposures. Which construction practice best addresses the concern that the portfolio may implicitly load on sector and size bets?
Imposing sector and size neutrality constraints in the optimization is the best approach. Low-volatility screens naturally concentrate in defensive sectors and larger stocks, so constraining those exposures to benchmark levels isolates the intended low-volatility tilt and limits unintended factor loadings.
- AImpose sector and size neutrality constraints relative to the benchmark in the optimizationCorrect
- BUse only the lowest-volatility stocks with equal weights and no constraints
- CIncrease turnover so factor exposure is rebalanced daily
- DRank stocks on volatility alone and ignore transaction costs
Explanation
Low-volatility screens tend to concentrate in utilities, staples and larger stocks. Constraining sector and size exposures to benchmark levels isolates the intended factor. Unconstrained selection or ignoring costs leaves or worsens the unintended bets.
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