FRM Part II · FRM Exam Part II · Factors
A fund's regression on the Fama-French three factors yields a statistically significant positive alpha. The same fund is then regressed on those factors plus a momentum factor, and the alpha falls to an insignificant level. What is the most appropriate conclusion?
The original alpha was largely compensation for momentum exposure rather than manager skill. Once momentum is included as a factor, that return is explained by the factor, so the unexplained alpha becomes statistically insignificant.
- AThe fund's original alpha was partly compensation for momentum exposure, not pure manager skillCorrect
- BThe momentum factor is irrelevant because alpha changed
- CThe manager has demonstrated greater skill after adding the factor
- DThe regression is invalid because adding factors can never change alpha
Explanation
Alpha is the return unexplained by the included factors. When an omitted factor with a premium is added and alpha vanishes, the earlier alpha reflected exposure to that factor (momentum) rather than skill. Adding factors can and does change alpha.
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