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FRM Part II · FRM Exam Part II · Factor Theory

A pension fund allocates to value, momentum, and low volatility factor strategies. The risk team wants diversification across factors during recessions, when factor returns are expected to be most stressed. Which consideration is most appropriate?

Allocation should be tested with stressed or regime-conditional correlations. Factor premia compensate for bad-times risk and correlations tend to rise in downturns, so full-sample estimates overstate diversification. Long-only factor tilts also keep significant market exposure, so they do not hedge recession risk.

  1. AFactor correlations are typically stable, so full-sample correlations suffice for stress planning
  2. BDiversification benefits across factors can shrink in bad times, so allocation should be tested using stressed or regime-conditional correlationsCorrect
  3. CFactor premia are riskless, so diversification is unnecessary
  4. DLong-only factor tilts have no exposure to the market factor

Explanation

Factor returns compensate for bad-times risk, and correlations among risky strategies often rise in downturns. Full-sample correlations can overstate diversification. Long-only tilts retain substantial market beta.

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