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FRM Part II · FRM Exam Part II · Factors

A fund sorts stocks on gross profitability, leverage and earnings stability, buying high scorers and shorting low scorers. Which statement best describes this factor and its relationship to value?

This is a quality factor. It favors profitable, low-leverage firms with stable earnings, which usually trade at higher valuations, so quality tends to be negatively correlated with value. That negative correlation makes combining quality and value attractive for diversification in a multi-factor portfolio.

  1. AIt is a quality factor, and it often has a negative correlation with value because high-quality stocks tend to trade at higher valuationsCorrect
  2. BIt is a size factor, and it is positively correlated with value because small stocks are cheap
  3. CIt is a momentum factor, and it is identical to value in construction
  4. DIt is a low-volatility factor, and it must have zero correlation with all other factors

Explanation

Sorting on profitability, leverage and earnings stability defines a quality factor. Quality stocks often trade at higher valuation multiples, so quality tends to be negatively correlated with value, which makes the two useful diversifiers in a multi-factor portfolio.

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