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FRM Part II · FRM Exam Part II · Factor Theory

A multi-factor equity fund holds large long exposures to value and momentum. During a sharp market rebound following a prolonged downturn, the fund suffers heavy losses driven by its momentum leg. Which explanation is most consistent with the empirical behaviour of momentum strategies?

The losses are consistent with momentum crashes. After a prolonged downturn, the loser stocks held short are often high-beta names that rebound violently when markets recover, producing sharp losses on the short leg. Momentum therefore has negative skewness and crash risk concentrated in market rebounds.

  1. AMomentum is prone to crashes when beaten-down losers rebound violently, so the short leg suffersCorrect
  2. BMomentum earns its highest returns in rebounds because losers keep falling
  3. CMomentum losses arise because value stocks always outperform in rebounds, offsetting the long leg
  4. DMomentum has a negative market beta in all regimes, so rebounds always help it

Explanation

Momentum crashes tend to occur after market declines followed by sharp rebounds. The short leg holds past losers, often high-beta stocks, which rally strongly and cause large losses. The claims that losers keep falling, or that beta is always negative, contradict this pattern. Value does not systematically offset in this way.

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