FRM Part II · FRM Exam Part II · Factors
A manager combines separate long-only single-factor smart beta portfolios (value, momentum, quality) into one multi-factor portfolio using equal allocations. The pairwise factor return correlations are low. What is the most direct benefit?
Combining factors with low correlations diversifies their cyclical underperformance, so active return volatility is lower than the weighted average of the individual factor portfolios. Factor premia stay risky and long-only portfolios retain market beta.
- AThe combined portfolio's tracking error is guaranteed to equal the average of the individual tracking errors
- BFactor premia become risk-free when combined
- CFactor cycles of underperformance partly offset, reducing the volatility of the active return relative to individual factor portfoliosCorrect
- DExposure to market beta is removed through diversification
Explanation
Low correlation among factor returns means one factor's weak period is partly offset by another's, lowering active return volatility below the weighted average. Tracking error is not a simple average, premia remain risky, and market beta persists in long-only portfolios.
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